Protecting Your Portfolio From Inflation Keith Black, PhD, CFA, CAIA Showcase your Knowledge @CAIA_Keith Black @CAIAAssociation
About CAIA Association The Global Leader in Alternative Investment Education Non-profit established in 2002, based in Amherst, MA, with offices in Hong Kong and London Over 8,000 current charter holders in more than 80 countries Over 24 vibrant chapters located in financial centers around the world More than 120 educational and networking events each year Offers AI education through the CAIA designation and the Fundamentals of Alternatives certificate program Inflation and Commodities 2
Alternative Investment Education Alternatives currently represent over $12 trillion in assets under management and assets in liquid alternatives continue to rise. The CAIA Association Mission: Establish the CAIA designation as the benchmark for alternative investment education worldwide Promote professional development through continuing education, innovative research and thought leadership Advocate high standards of professional ethics Connect industry professionals globally Inflation and Commodities 3
The CAIA Charter Designation Globally recognized credential for professionals managing, analyzing, distributing, or regulating alternative investments. Highest standard of achievement in alternative investment education. Comprehensive program comprised of a two-tier exam process: Level I assesses understanding of various alternative asset classes and knowledge of the tools and techniques used to evaluate the risk-return attributes of each one. Level II assesses application of the knowledge and analytics learned in Level I within a portfolio management context. Both levels include segments on ethics and professional conduct. Inflation and Commodities 4
Fundamentals of Alternative Investments The Fundamentals of Alternative Investments Certificate Program is a course that provides a foundation of core concepts in alternative investments. Fills a critical education gap for those who need to understand the evolving landscape of alternative investments. Online, 20-hour, self-paced course Earns CE hours for the CIMA, CIMC, CPWA, CFP designations Understand the core concepts in alternative investments Gain confidence in discussing and positioning alternatives Inflation and Commodities 5
CAIA Curriculum Level I Chapter 10: Natural Resources and Land Chapter 12: Commodities: Applications and Evidence Level II Chapter 3: Risk Management for Endowment and Foundation Portfolios Chapter 24: Role of Commodities in Asset Allocation Chapter 27: Macroeconomic Determinants of Commodity Futures Returns Inflation and Commodities 6
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 Inflation and Commodities 7
Inflation Uncertainty 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 Source: Barclays Inflation and Commodities 8 8
Hedging Inflation US Consumer Price Index, January 2016 Other Goods and Services 34.4% Housing 33.2% Food and Energy 20.8% Medical and Education 11.6% USCPI, 2015 Inflation and Commodities 9
Inflation Betas 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) 20 Year US Treasuries S&P 500 3 Month T- bills 10 Year TIPS Farmland -3.1-2.4 0.3 0.8 1.7 6.5 Commodity Futures 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 riskadjusted returns Bernstein Global Wealth Mgmt, Deflating Inflation: Redefining the Inflation-Resistant Portfolio, 2010 Inflation and Commodities 10
Inflation-Linked Bonds Sovereign debt issues offer a real yield with an inflation-adjusted principal value 10 year US TIPS offer a real yield of less than 0.4% Break-even yield implies 1.55% future inflation, down from 2.5% last year 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 Bernstein Global Wealth Management, Deflating Inflation: Redefining the Inflation-Resistant Portfolio, 2010 Inflation Barclays, and The Commodities Global Inflation-Linked 11 Monthly Reflation and the Front End, November 2015 11
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 Rising Inflation Leaders to Higher Earnings but a Higher Discount Rate Hurts Valuations Bernstein Global Wealth Mgmt, Deflating Inflation: Redefining the Inflation-Resistant Portfolio, 2010 Inflation and Commodities 12
Real Estate and REITs Real estate investments are a hybrid between fixed income and equity securities, with inflation hedging potential depending on property income and debt structure 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 Inflation and Commodities 13
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 Martin, The Long-Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio, Journal of Alternative Investments, 2010 Inflation and Commodities 14
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 orchards 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 Bernstein Global Wealth Mgmt, Deflating Inflation: Redefining the Inflation-Resistant Portfolio, 2010 Inflation and Commodities 15
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 Inflation and Commodities 16
Commodity Inflows Source: CFTC, Citi Research, September 2015 Inflation and Commodities 17 17
Commodity Futures Indices S&P GSCI Commodity Index, 2016 Weights Bloomberg Commodity Index, 2016 Target Weights Precious Metals 3% Industrial Metals 9% Grains, Meats, Softs 24% Energy 63% Grains, Meats, Softs 36% Energy 31% Precious Metals 16% Industrial Metals 17% S&P GSCI, 2016 Bloomberg, 2016 Inflation and Commodities 18
Diversification Potential of Commodities Commodity Index Performance 20-Year History (through December 2014) Commodity Index Performance S&P GSCI Bloomberg Annualized Total Return* 4.6% 4.5% Annualized Std. Dev. 22.1% 15.8% Sharpe Ratio 0.07 0.09 Maximum Drawdown -70.9% -59.8% Correlation with S&P GSCI 1 0.90 Correlation with Bloomberg 0.90 1 U.S. and Global Stock and Bond Index Barclays Capital MSCI JPM Credit Suisse Credit Suisse Performance S&P 500 U.S. Bond World Equity Global Bond HFI Managed Futures HF Annualized Total Return** 10.6% 6.1% 8.0% 5.8% 9.0% 5.8% Annualized Standard Deviation 15.1% 3.5% 15.2% 5.8% 7.1% 11.7% Sharpe Ratio 0.50 0.86 0.33 0.48 0.84 0.24 Maximum Drawdown -56.5% -5.8% -56.0% -12.3% -22.8% -23.9% Correlation with S&P GSCI 0.25 0.01 0.34 0.20 0.38 0.15 Correlation with Bloomberg 0.33 0.06 0.42 0.29 0.42 0.22 * Total Return Indices include the return of 91-day Treasury Bill yield. ** Includes reinvestment of dividends and interests. CISDM Indices are net of manager fees. Inflation and Commodities 19
Attractive Correlation Characteristics Commodity futures returns have attractive correlation characteristics over long time periods Stocks Bonds Inflation 1 Year 0.04-0.25 0.24 5 Years -0.26-0.25 0.47 Gorton/Rouwenhorst, Facts and Fantasies about Commodity Futures Ten Years Later, 2015 Inflation and Commodities 20
Trends in Correlation Bhardwaj/Gorton/Rouwenhorst, Facts and Fantasies about Commodity Futures Ten Years Later, 2015 Inflation and Commodities 21
Commodity Stocks vs. Futures Source: Wall Street Journal, August 2015 Inflation and Commodities 22
Jan-94 Jun-94 Nov-94 Apr-95 Sep-95 Feb-96 Jul-96 Dec-96 May-97 Oct-97 Mar-98 Aug-98 Jan-99 Jun-99 Nov-99 Apr-00 Sep-00 Feb-01 Jul-01 Dec-01 May-02 Oct-02 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Hedging Inflation 36 Month Rolling Correlation to Inflation Stocks vs. Commodities 0.60 0.50 0.40 0.30 0.20 0.10 0.00-0.10-0.20-0.30-0.40-0.50 S&P 500, Bloomberg, 2014 S&P 500, CPI Bloomberg Commodity Index, CPI Inflation and Commodities 23
Timing Commodity Investments X. Kang, Commodity Investments: The Missing Piece of the Portfolio Puzzle?, S&P Dow Jones Indices, 2012 24 Inflation and Commodities 24
Supply Constraints Commodities with supply constraints can have higher volatility and greater upside potential Energy and Industrial Metals (Volatility of 32% and 21%) These commodities have the greatest supply constraints, as production is subject to location, mining/drilling, refining and environmental issues Agriculture (Volatility of 18%) Supply shortages tend to be short lived, as next year s growing/breeding season may overcome this year s shortages Precious Metals (Volatility of 16%) Supply has little impact, as metals are held for centuries as a store of value and little is consumed Inflation and Commodities 25
The Role of Emerging Markets The prices of many commodities are tied to the demand from Asian emerging markets India and China are rapidly gentrifying nations with over 2.5 billion of the world s 6.8 billion citizens This consumption relative to world demand is falling. Consumption of cement, steel, aluminum, coal and copper grew by over 10% annually from 2006 to 2011, but growth has slowed in recent years Chinese Commodity Consumption as a Portion of World Demand Cement 2 Soybeans 1 Coal 3 Copper 1 Iron Ore 1 Aluminum 4 55% 66% 50% 44% 66% 45% 1) Wall Street Journal, 2013 2) Societe Generale, 2010 3) Energy Trends Inside, 2012 4) Morgan Stanley, 2012 Inflation and Commodities 26
U.S. Supply Now Declining Inflation and Commodities 27 27
But OPEC Supply Increasing Inflation and Commodities 28 28
Inventories are Still High Inflation and Commodities 29 29
Reasons for Selloff: Demand Inflation and Commodities 30 30
Supply Outpacing Demand Inflation and Commodities 31 31
Reasons for Selloff: Demand Falling commodity prices closely related to declines in emerging markets, from GDP and industrial production to currency and equity prices Inflation and Commodities 32 32
Reasons for Selloff? USD Strength USD commodity prices falling much faster than when purchased using weak Euro or emerging market currencies Weak EM currencies encourage local producers to increase exports Inflation and Commodities 33 33
CAIA Curriculum Level I Chapter 10: Natural Resources and Land Chapter 12: Commodities: Applications and Evidence Level II Chapter 3: Risk Management for Endowment and Foundation Portfolios Chapter 24: Role of Commodities in Asset Allocation Chapter 27: Macroeconomic Determinants of Commodity Futures Returns Inflation and Commodities 34