For many investors, diversification means making sure their investment portfolio contains stocks, bonds, cash, a bit of international exposure and not much else. That’s because most traditional diversification strategies emphasize financial assets as the primary portfolio building blocks.
But for other investors — particularly those seeking enhanced diversification and a potential hedge against inflation — another asset class fits the bill: Real assets. Whether real estate, gold, oil, minerals or Treasury Inflation Protected Securities (TIPS), real assets can deliver robust diversification benefits due to their often-negative correlation with stocks and bonds. However, real assets may also provide another key benefit, particularly if the economy starts to show signs of recovery in the coming months: Real assets can act as a hedge against the threat of inflation.
“Investments in real assets such as commodities, real estate or TIPS can act as an insurance policy for the rest of an investor’s portfolio,” says John Skjervem, chief investment officer for Northern Trust’s Personal Financial Services division. “Real assets offer a unique value proposition in that they tend to retain value in an inflationary environment that can otherwise undermine — and in some severe cases, destroy — financial assets.”
An Inflationary Cycle
In recent years, inflation has taken a back seat to investors’ other concerns, such as market volatility and weaker corporate balance sheets. But that doesn’t mean inflation has disappeared altogether from the list of issues that can damage a portfolio. In fact, according to some projections, the start of an inflationary cycle that could prove problematic for consumers and investors in the medium- to long-term may have already begun.
As a result, buying an insurance policy against the negative effects of inflation on your portfolio now may make a lot of sense. Why now? The answer is simple: For the same reason that you buy homeowner’s insurance even though you don’t expect your house to burn down, adding an inflation hedge to protect real portfolio returns can make sense. And the time to buy protection — whether for your home or your portfolio — is before you have a problem.
One of the advantages to adding real assets such as commodities as an inflation hedge is that when inflation comes, real assets often behave differently than financial assets such as fixed-income or equity securities. First, real assets usually have a low correlation with financial assets, meaning real assets can act as an effective counterbalance to declining financial asset values. Equally important, however, is that real assets, including commodities, tend to increase in value during the expansion phase of a business cycle.
Inflation is defined as a general price increase among a basket of goods and services, and in an inflationary environment, commodity prices are likely to go up, too. At the same time, high inflation often drives down the price of stocks and bonds, which is why commodity prices tend to have a low correlation with financial asset investments.
The Threat of Inflation
Over the past two decades or so, many investors have viewed the threat of inflation with a certain amount of skepticism, particularly in light of skillful efforts by the U.S. Federal Reserve to keep inflation low. This attitude makes a certain amount of sense, considering that inflation has remained below 3% for much of the last 10 years.
Nevertheless, inflation has never completely gone away as a threat to portfolio values, especially for those investors whose portfolios are comprised primarily of financial assets. That’s because every increase in the inflation rate negatively affects both long-term capital preservation and wealth accumulation, diminishing the portfolio’s real, total return.
“Investors should view inflation as one of the most pernicious threats to their portfolio,” says John Skjervem, chief investment officer for Northern Trust’s Personal Financial Services division. “That’s because, at high rates, inflation erodes the real purchasing power of the portfolio’s financial assets. Traditional bonds are most vulnerable, but equities, too, can be adversely affected. So it’s important to take the possibility of inflation seriously in portfolio construction.”
Today, a growing number of economists and investors are eyeing the threat of inflation with renewed concern. “The risk of inflation down the road is two-fold,” says Jim McDonald, chief investment strategist for Northern Trust. “First, the potential exists that today’s excess capacity in the economy gets permanently removed from production, such as in a downsized auto industry.” The second primary inflation risk is that central banking authorities wait too long to remove their monetary stimulus efforts and inflationary expectations start to build among consumers, which in turn leads to increasing demands for higher wages. As a result, government stimulus programs may result in a classic case of “too many dollars chasing too few goods” down the road, McDonald says, reducing prospects for an economic recovery while still leading to higher inflation.
Granted, McDonald and others don’t foresee a return to the early 1980s and double-digit inflation anytime soon. More likely is the return of mild inflation some time in 2011 or 2012. However, because inflation often follows on the heels of a recovery, economists are keeping an eye on the possibility — however unlikely — that inflation may soon go higher.
Choosing a Real Asset
The entire category of real assets includes a range of potential investments, including real estate, gold and other commodities such as oil, minerals and agricultural products. Each of these, however, has its own return and volatility characteristics, and may or may not serve as an effective inflation hedge at any given time. Real estate, for example, is often subject to unique supply-and-demand or financing dynamics that are separate from other real assets and not always closely correlated with inflation.
“When choosing a real asset to invest in, it’s important to understand the real asset’s correlation with other investments in the portfolio, such as stocks or bonds, and the real asset’s direct correlation with inflation,” says Jim McDonald, chief investment strategist for Northern Trust. “For example, in 2008, commodities, as an asset class, went down every bit as much as stocks. So what’s important is making sure an investment is directly correlated with inflation, and not necessarily correlated with the performance of other portfolio investments.”
Whether real estate, gold, oil, minerals or Treasury Inflation Protected Securities (TIPS), real assets can deliver robust diversification benefits due to their often-negative correlation with stocks and bonds.
The Real Value of Real Estate
One such real asset is, of course, real estate. Often considered attractive by investors for both its income producing and inflation hedging benefits, real estate as a broad asset class encompasses several different property types each with different risk and return characteristics.
The most accessible form of real estate investment is public real estate equities, although public and private debt investments (including mortgages) also provide investors with real estate investment exposure. Historically, the best real estate inflation hedge, however, has been available from private investments in those property types with the shortest lease terms such as hotels that can raise rates nightly. The potential inflation hedge benefit is lessened as you move to public real estate alternatives such as stocks issued by real estate investment trusts (REITs). Nevertheless, in an inflationary environment, REITs are likely to still outperform a broader equity universe as investors anticipate REIT operators’ ability to raise rents and pass through operating expenses when inflation accelerates.
An Inside TIPS on Inflation
Real assets also include inflation-protected financial securities, such as TIPS, that provide a total return tied directly to the actual inflation rate. Inflation-indexed bonds issued by the U.S. Treasury, TIPS’ principal value is regularly adjusted to reflect changes in the Consumer Price Index (CPI), the most commonly used measure of inflation. With TIPS, your portfolio benefits from owning U.S. government securities that offer protection from geopolitical turmoil or a financial system downturn like a traditional treasury security, while also preserving value if the inflation picture turns out worse than expected.
“The definition of real assets is that they have a high, positive correlation with inflation,” Skjervem says. “As a result, TIPS represent a good inflation hedge because their value is directly tied to changes in the CPI. That means when you add TIPS to your portfolio, you’re not buying them to maximize return, but rather to provide portfolio stability and inflation protection.”
The Value of Being Prepared
With the unemployment rate still rising, it seems unlikely that higher wages will generate serious inflation in the foreseeable future. And, as weak consumer demand continues to challenge corporate profits, the potential for higher prices for consumer goods is likely to remain muted until the recovery gathers steam and enters a full-fledged expansion. Nevertheless, real assets such as commodities, gold and real estate may continue to benefit investors as they seek quality investments in an economic downturn.
But if and when inflation returns, it’s important to be prepared, and real assets can provide an effective hedge against the adverse consequences of inflation. Taking steps now to protect your portfolio against inflation may prove to be a wise move down the road.
Diversification does not guarantee against loss.