PROTECTING YOUR PORTFOLIO FROM INFLATION KEITH BLACK, PHD, CFA, CAIA SHOWCASE YOUR KNOWLEDGE

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1 PROTECTING YOUR PORTFOLIO FROM INFLATION KEITH BLACK, PHD, CFA, CAIA SHOWCASE YOUR KNOWLEDGE

2 THE CAIA PROGRAM The Chartered Alternative Investment Analyst (CAIA) curriculum covers the following topics: Ethics and professional standards, hedge funds, private equity, real assets, commodities and structured products Over 20% of the program material is dedicated to inflation-sensitive assets Over 6,000 members worldwide have earned the CAIA designation 75% of candidates are from the US, UK, Switzerland, Hong Kong, or Singapore Members are typically employed as Portfolio managers, consultants, marketers, asset allocators, analysts, or risk managers

3 WHY HEDGE INFLATION? Most investors think in terms of nominal returns, especially in the fixed income markets However, rising inflation makes it more difficult to meet terminal wealth goals in nominal terms Investors with a greater need for inflation protection will choose larger allocations to real assets Endowments and foundations who seek to maintain real spending while preserving the real value of the endowment Pensions who offer cost-of-living (COLA) adjustments to their retirees Corporations or individuals with fixed incomes, but expenses that grow with inflation

4 INFLATION UNCERTAINTY IS HIGH With global fiscal and monetary stimulus, the uncertainty of future inflation is high While money supply growth is high, significantly higher inflation is unlikely to come until employment and production levels increase

5 DEFINING INFLATION 5 US Consumer Price Index, December 2012 Other Goods and Services 29% Housing 32% Commodities 23% Medical and Education 14%

6 INFLATION BETAS 6 Where can institutional investors turn to hedge their inflation risk? Studies have found that a few assets can hedge inflation risk (positive inflation beta), while the majority of institutional assets have a risk to rising inflation (negative inflation beta) Within equities, smaller cap stocks and less capital intensive sectors have even greater inflation risk In practice, many institutions build a real assets allocation, investing 5% to 20% of the portfolio in timberland, farmland, linkers and commodity futures Assets with superior inflation protection may have lower risk-adjusted returns Source: Deflating Inflation: Redefining the Inflation-Resistant Portfolio, Bernstein Global Wealth Mgmt, 2010

7 INFLATION-LINKED BONDS Sovereign debt issues offer a real yield with an inflation-adjusted principal value 10 year US TIPS offer a negative real yield Break-even yield implies 2.5% future inflation Bernstein estimates an inflation beta of 0.8 Holding non-usd issues can hedge the declining value of the dollar, but are more sensitive to local country inflation $2.3 trillion issued worldwide Approximately 30% in US, 40% in UK and Eurozone 30% in Canada, Australia, Japan, Sweden, Iceland, Emerging Markets Source: Deflating Inflation: Redefining the Inflation-Resistant Portfolio, Bernstein Global Wealth Mgmt, 2010

8 COMMODITY FUTURES Commodity futures returns have attractive correlation characteristics over long time periods Diversify across energy, industrial and precious metals, and agricultural products Bernstein estimates an inflation beta of 6.5 Source: Gorton/Rouwenhorst, Facts and Fantasies about Commodity Futures, Financial Analysts Journal, 2006

9 TRENDS IN COMMODITY CORRELATION 9

10 EQUITIES Equities have high long-term returns, but suffer in the short run from higher interest rates during times of inflation Firms in the natural resource, energy and real estate sectors have greater inflation protection than broad equity indices Energy and metals stocks have an inflation beta of 2, REITs of -2, and S&P 500 of -2.4 Smaller stocks and less capital intensive stocks get hurt the most by rising inflation

11 REAL ESTATE AND REITS Real estate investments are a hybrid between fixed income and equity securities Long-term leases are similar to fixed income instruments, as fixed rate leases suffer from higher discount rates Property equity can act like stocks, rising with long-term inflation Short-term effects are negative for both REITs and private real estate partnerships

12 TIMBERLAND Like real estate, the land value can be negatively affected by inflation Like commodities, timber values are positively affected by inflation Can be correlated to economic activity, especially housing starts Interesting real options characteristics, where waiting to harvest during times of low prices can lead to another year of biological growth Source: Martin, The Long-Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio, Journal of Alternative Investments, 2010

13 FARMLAND Unlike infrastructure or real estate, the supply of farmland is fixed or shrinking despite growing demand for food Returns may be leveraged to growth in population and income in emerging markets Commodity-based rents benefit from short-term inflation Bernstein estimates an inflation beta of 1.7 Permanent crops, such as crops or citrus, have different characteristics than row crops Row crops, such as corn or wheat, have annual option to switch to a more profitable crop

14 INFRASTRUCTURE AND MLPS Toll roads, pipelines, ports and utilities can benefit from inflation when user fees increase at a greater rate than expenses Infrastructure is a hybrid asset class, having characteristics of fixed income, real estate and private equity Many infrastructure assets have low price elasticity of demand, making the cash flows somewhat recession proof Some contracts to operate regulated assets include inflation escalation clauses Investment opportunities may be large due to growing energy demand, governmental budget deficits and needs for infrastructure growth and rehabilitation

15 SUMMARY OF REAL ASSET CHARACTERISTICS Source: Martin, The Long-Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio, Journal of Alternative Investments,

16 SHOWCASE YOUR KNOWLEDGE