Aiming at a Moving Target Managing inflation risk in target date funds Executive Summary This research seeks to help plan sponsors expand their fiduciary understanding and knowledge in providing inflation protection to target date funds. In this paper, we explore the challenge of implementing inflation protection within a pooled fund vehicle, specifically examining how to forge an effective link between individual investor objectives and appropriate fiduciary decisions on behalf of the entire investor pool. This analysis is an extension of previous target date research in our Ready! Fire! Aim? series, in which we discussed target date investing as a balance between maximizing upside potential while minimizing the risk of downside outcomes. As fiduciaries, we believe that an appropriate target date strategy will place more emphasis on downside protection. We see inflation risk, or the risk of negative real returns, as part of the overall challenge of protecting investors against downside outcomes. Inflation hedging: No silver bullet Our research makes a strong empirical case that the risk of negative real returns is cyclical and is present in all inflationary regimes, both high and low. Managing this risk, therefore, is an all season effort to protect the portfolio in all inflationary environments. It also requires protecting investors against other factors that may interact with inflation, i.e. business cycles, to create downside outcomes.
Aiming at a Moving Target For this reason, it is our view that there is no silver bullet when it comes to inflation protection. No single asset or hedging strategy can protect a portfolio against all the variability in the inflationary and economic regimes that it will encounter. Inflation: An ever-present risk As shown in Exhibit 1, inflation spikes are, in historical terms, relatively rare. More commonly, inflation remains contained: the most common inflation risk scenario is a period of low inflation combined with a bear market, producing negative real returns. Thus, the risk of negative real returns happens most commonly during periods of low inflation, not high inflation. Exhibit 2 Seeks to illustrate this danger, showing that down business cycles can often produce negative nominal returns Exhibit 1: U.S. inflation, year-over-year INFLATION % 25 20 15 10 5 0-5 -10-15 '27 '33 '39 '45 '51 '57 '63 '69 '75 '81 '87 '93 '99 '05 '08 Based on quarterly total returns, 1978 Q1 to 2008 Q2 CPI headline inflation, Bureau of Labor Statistics Exhibit 2: Business and inflation cycles % 14 12 10 8 6 4 2 0-2 Business cycle Y-O-Y inflation -4 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 while inflation is contained. The key takeaway is that while inflation spikes are rare, recessions, contractions and bear markets are not. Moreover, inflationary regimes differ as to their causes. Sometimes inflation is driven by price inflation, but at other times it is driven by monetary inflation. Assets respond differently to each type of regime. Thus, if an inflation protection works well under one regime, it does not guarantee future success under different inflationary scenarios. Therefore, investors who focus their inflation protection strategies exclusively on shocks, specifically and a single type of shock, will be leaving their portfolios vulnerable to many other inflation dangers. Comprehensive all season planning is the key to success because the nature of the inflationary regime is not known in advance nor is its level, length or causes or what other risks may appear contemporaneous with it, exacerbating its dangers. Asset class risks and cyclical sensitivities In addition to the unpredictable cyclicality of inflation, all hedging assets bring unique cyclical risks inconsistencies in their response to inflation and business cycle, as well as bubbles and bear markets that can form quite independently from inflation. Exhibits 3 and 4 illustrate such cyclicalities, in relation to inflationary regimes and business cycles. First, one should notice that the direction of inflation is just as important as its level. Some assets show a rapid, large reversal in returns depending not on whether inflation is high or low, but rather on whether inflation is rising or falling. Second, economic cycles can have a similar performance impact. Assets that show the highest sensitivity to recession also tend to have the strongest performance in recovery. For example, commodities maintain their high returns as the economy slows, i.e. contraction, but swing to double-digit declines during recessions, and then rapidly reverse to double-digit gains in a recovery. Managing these cycles can be challenging, given that: Asset returns respond before any underlying economic change is reflected in government statistics. Business Cycle estimated by Y-O-Y change in U.S. non-farm payroll 2 Aiming at a Moving Target: Managing inflation risk in target date funds
Exhibit 3: Asset returns by inflation environments (1970 2008) Contained Inflation Inflation Shocks High and Rising High and Falling U.S. Large Cap Equity 17.1% -7.1% 18.9% U.S. Small Cap Equity 13.7% -5.8% 24.0% International Equity 30.6% -8.7% 6.4% Emerging Markets Equity 24.0% 0.4% 23.8% Emerging Market Debt 13.8% -0.9% 19.6% High Yield 11.8% -2.6% 20.8% U.S. Core Fixed Income 8.19% 4.3% 4.3% Cash 5.8% 6.5% 7.9% TIPS 5.6% 18.4% 8.0% Commodities 18.9% 48.2% -1.6% REIT 13.6% -14.1% 27.0% Direct Real Estate 10.3% 9.6% 12.5% Inflation 3.1% 6.7% 6.8% # Months 266 94 94 Exhibit 4: Asset returns by stage of business cycle (1970 2008) Expansion Contraction Recession Recovery U.S. Large Cap Equity 11.7% 6.0% 10.8% 22.2% U.S. Small Cap Equity 14.6% 2.6% 18.1% 46.2% International Equity 15.9% 7.7% -1.4% 18.3% Emerging Markets Equity 12.6% 8.9% 9.9% 36.4% Emerging Markets Debt 8.9% 10.0% 9.8% 13.5% High Yield 7.2% 6.1% 9.6% 16.0% U.S. Core Fixed Income 4.9% 9.8% 11.1% 10.2% Cash 5.4% 7.1% 5.9% 4.9% TIPS 8.2% 18.7% -5.5% -0.1% Commodities 12.9% 21.2% -11.8% 15.9% REIT 17.0% -0.3% 6.9% 20.9% Direct Real Estate 12.7% 11.5% 4.6% 2.9% Inflation 4.2% 6.1% 4.1% 3.7% # Months 150 175 37 51 U.S. Large Cap Equity S&P 500 Total Return Index U.S. Core Fixed Income Barclays Capital Aggregate Bond Index U.S. Small Cap Equity Russell 2000 Total Return Index Emerging Markets Equity MSCI Emerging Market Free Index Emerging Market Debt JPMorgan EMBI Global Index Commodities Goldman Sachs Commodities Index (GSCI) TIPS Barclays Capital Inflation Linked Index, and TIPS Back-tested historical returns: returns estimated from backfilled TIPS yields = nominal yields expected inflation TIPS premium (average premium * inflation volatility) High Yield Barclays Capital High Yield Index REIT NAREIT Equity Index Direct Real Estate NCREIF Index International Equity MSCI EAFE (USD) Index Inflation is shown as an average annualized percentage for the relevant periods J.P. Morgan Asset Management 3
Aiming at a Moving Target Inflation and economic cycles can reverse quickly, with rising and falling cycles coming in quick succession. The scale of the potential shift in asset performance can be enormous as well as rapid. Thus, investors should be wary of creating a whipsaw effect by using narrow hedging strategies and trying to time hedges too closely. Again, the wide variability in risk supports the idea that an all season approach to inflation protection, such as multiple asset classes and multiple hedging strategies, is the most effective way to minimize the widest possible range of inflation cycle, business cycle and asset class risks. Time horizon: A key issue for target date funds Given the cyclicality and unpredictability in inflation regimes, as well as the variability in asset classes reaction to inflation and economic cycles, it should not be surprising that shortterm volatility is a chief concern in designing effective inflation protection. As target date investors time horizons shorten, they face a steadily increasing risk of negative real returns close to retirement, which would erode purchasing power without sufficient time to recover it before those funds are needed. As such, it raises an important question: Over what time horizon are investors most vulnerable to such a risk? Exhibit 5: Probability of beating inflation over rolling periods % Probability 100 90 80 70 Direct real estate Commodities 60 U.S. Core Fixed Income REITs U.S. Large Cap Equity 50 Quarterly 1 year 2 years 3 years 5 years 10 years Holding Period 22 quarters are represented; as a result, there are 119 rolling 1-year results, 115 rolling 2-year results, etc. NCREIF, Barclays Capital Aggregate Bond Index, NAREIT Equity Index, S&P 500 Total Return, J.P. Morgan equal weighted proprietary backtested commodities index Based on quarterly total returns, 1978 Q1 to 2008 Q2 Historical analysis indicates that in periods longer than 10 years all individual asset class returns beat inflation (Exhibit 5). However, even in periods shorter than 10 years, we could not identify a single period in which all assets failed to beat inflation. That is, investors using diversified portfolios would likely own at least one asset that beats inflation, providing further support for the notion that diversified all season hedging strategies are most effective in protecting against a wide variety of inflation risks. Based on this view of time horizons, a conservative approach would set the outer boundary of inflation sensitivity at 10 years and investors should begin to worry about inflation 10 years before the expected retirement date, such as the end point of the investing horizon, with inflation sensitivity increasing steadily as the time horizon shortens. For target date investors, however, the real end point of the time horizon is fluid, having less to do with age and more to do with the decision to shift from saving to spending, which is highly dependent on personal circumstance. Thus, with the fiduciary s goal of balancing the needs of the investment pool with the needs of the individual investor, sponsors should think of the end point more in terms of a band in which the inflation sensitive period could begin as early as age 50 or as late as age 60. Managing other critical issues: Volatility, growth, and liquidity Factors other than short-term asset performance can also influence risk tolerance such as low contribution rates, participant loans and early withdrawals. Any such reductions in the savings rate can increase investors vulnerability to downside outcomes and in turn reduce the portfolio s tolerance for volatility. Therefore, plan sponsors should take into account participant behavior patterns when assessing volatility risk. Given these concerns, volatile assets like commodities become riskier the closer the portfolio gets to the target time-band for retirement. As a result, managers and plan sponsors must reassess the use of potentially volatile assets, asking how much is required to gain meaningful inflation protection, and at what price to the portfolio in terms of volatility. 4 Aiming at a Moving Target: Managing inflation risk in target date funds
In addition, inflation protection can impose portfolio costs in terms of lower growth. In times of low inflation, which are much more common than inflationary shocks or spikes, TIPS returns could fall short of returns for core fixed income; investors end up paying a premium for inflation insurance that they are not using. Target date sponsors also need to consider striking an effective balance between protecting against negative real returns and meeting growth targets. Finally, certain assets such as direct real estate may provide robust inflation protection, but may also compromise other portfolio objectives, like liquidity. As withdrawals increase, large positions in illiquid assets can compromise the fund s ability to meet cash flow demands. In addition, the fund may not be able to liquidate certain assets fast enough to maintain its target allocation. To address the latter challenge, fiduciaries may under-allocate to their ideal target weight in illiquid assets as the fund approaches its target retirement date. Then if such withdrawals occur, the effective allocation to the illiquid asset classes rises to its target, rather than above it. Connecting the dots: Diversification across the target date glide path The fiduciary goal of minimizing downside outcomes, rather than maximizing the potential upside, brings with it a built-in bias toward steady reductions in volatility as the portfolio progresses along the glide path. This approach has the additional benefit of helping to minimize the risk of negative real returns prior to retirement too. We demonstrate this with the glide path of the J.P. Morgan SmartRetirement strategy (Exhibit 6). With 40 years to retirement, this glide path starts out on the left of the graph with a relatively high allocation to risk assets such as equities and extended fixed income, almost 90%, and moves to a low volatility, low equity position, about 30%, at the point of retirement, at the far right of the glide path. This allocation is maintained throughout retirement, as the constant allocations indicate. Exhibit 6: sample glide path allocations* Cash TIPS U.S. Core Fixed Income High Yield Emerging Markets Debt Emerging Market Equity International Equity U.S. Small Cap Equity U.S. Large Cap Equity REITs Direct Real Estate 100 90 80 70 % of Portfolio Allocation 60 50 40 30 20 10 0 25 30 35 40 45 50 55 60 65 70 75 80 Participant Age Source: J,P. Morgan Asset Management J.P. Morgan Asset Management 5
Aiming at a Moving Target Asset classes which are added at a specific point in the glide path, like TIPS, need to be incorporated gradually rather than added all at once at the full target weight. This is done to manage market timing risk with respect to inflation assets and the overall level of volatility in the portfolio. It is important to minimize market timing risk, particularly when adding inflation sensitive assets. Since large swings in returns can occur quickly as inflation moves from rising to falling, adding significant hedging assets at a single point in time runs the risk of adding the assets at the worst and most expensive part of the cycle. Dollar-cost-averaging into the position by incrementally adding to the asset as the glide path changes limits potential damage to the portfolio if an asset is added at a cyclical high, since only a fraction of the total position will be added at the highest price. And by extension, any significant changes to asset allocations, such as the reduction of risk assets overall, should be done gradually for the same reason. Real assets in target date funds The need for lower portfolio volatility during the pre-retirement phase of the glide path can affect the attractiveness of certain assets that are sometimes touted as a silver bullet for inflation protection, namely real assets. In our empirical analysis, commodities emerged as one of the most attractive real assets over longer time horizons. However, their potentially high volatility makes them inappropriate for target date funds during the relatively short time period just prior to retirement where inflation protection is most important. Direct real estate appears to be the most attractive real asset for this pre-retirement phase. It shows low volatility and still achieves high relative growth rates. It may, however, pose liquidity constraints, and it may be out of reach for some noninstitutional investors. Diversification: The best weapon against inflation For target date funds, inflation protection is a fiduciary goal: minimizing the risk of downside outcomes and achieving an effective balance between individual needs and the interests of the entire investor pool. Sponsors seeking to protect investors from negative real returns must simultaneously address three issues that play a key role in managing downside risk: growth, volatility and liquidity. In this regard: Narrow solutions are inappropriate. They do not work consistently because they cannot account for all the variables in inflation, business cycle and asset class risks. Diversified target date portfolios with some real assets may already be well positioned for inflation protection. The level of general diversification and volatility has a bigger impact on inflation shortfall than real assets. During the last 10 years of the time horizon, when investors are most vulnerable, volatility reduction will provide the greatest degree of protection from negative real returns particularly in low inflation environments. For the shortest of time horizons, however, the risk of negative real returns can never be entirely eliminated. It is up to target date fund sponsors to assess how great the residual risk is for the target time period. Then they must make a balanced fiduciary decision regarding the trade-offs necessary to mitigate that risk, i.e. making a growth trade-off in exchange for shortterm inflation protection, or accepting additional volatility and inflation risk in an effort to maintain the portfolio s growth. Finally, we would encourage investors to raise the question of inflation risk in the context of overall portfolio construction. The holistic approach we have outlined supports the notion that inflation hedging should not be approached as a portfolio add-on, but rather as a core component of the portfolio modeling and construction process. TIPS appear to provide effective inflation protection when inflation spikes, but these regimes are rare. And during periods of low inflation, TIPS may dampen the portfolio s growth potential. Combining TIPS with REITs, however, may be an appropriate, effective investment, particularly if direct real estate is not incorporated. 6 Aiming at a Moving Target: Managing inflation risk in target date funds
Authors Anne Lester Managing Director Senior Portfolio Manager Global Multi-Asset Group Katherine Santiago, CFA Quantitative Research Analyst Global Multi-Asset Group Key Contributor Michael Giliberto Managing Director Portfolio Manager Global Real Assets Group J.P. Morgan Asset Management 7
IMPORTANT DISCLAIMER This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. All charts and graphs are shown for illustrative purposes only. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. The value of investments and the income from them may fluctuate and your investment is not guaranteed. Past performance is no guarantee of future results. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. 245 Park Avenue, New York, NY 10167 2009 JPMorgan Chase & Co. www.jpmorgan.com/insight