Supplementing index-linked bonds with alternative investments in the liability-matching portfolio can take some pressure off of the return-seeking portfolio - thereby improving risk  management, argues Lionel Martlellini

Despite the current credit crisis and consequent economic slowdown that have somewhat eased inflation concerns for the short term, increasing inflation is a trend that is likely to continue given the long-term increased demand pressure on food and energy resources.

Inflation hedging is particularly important for pension funds facing pension payments that are indexed to consumer prices or wage levels indexes. A variety of cash instruments (Treasury inflation protected securities, or TIPS) as well as dedicated OTC derivatives (such as inflation swaps) are typically used to tailor customised inflation exposures suited to each particular pension fund liability profile. But these solutions generate very modest performance. In fact, real returns on inflation-protected securities, negatively impacted by the presence of a significant inflation risk premium, are typically very low.

Besides, the capacity of the inflation-linked securities market is not sufficient to meet the collective demand of institutional and private investors, while the OTC inflation derivatives market suffers from a perceived rise in counterparty risk.
In this context, it has been argued that other asset classes, such as stocks and nominal bonds, and also real estate or commodities, could provide useful, albeit imperfect, inflation protection at a lower cost compared with investing in TIPS.

On the one hand, equity investments appear to be relatively poor inflation-hedging vehicles from a short-term perspective. Empirical evidence suggests that there is in fact a negative relationship between expected stock returns and expected inflation (see Fama and Schwert (1977), Gultekin (1983) and Kaul (1987) among others), which is consistent with the intuition that higher inflation leads to lower economic activity (for example, Fama (1981)). On the other hand, higher future inflation leads to higher dividends (Campbell and Shiller (1988)), and thus equity investments should offer significant inflation protection over longer horizons, as a number of recent empirical academic studies show (Boudoukh and Richardson (1993) or Schotman and Schweitzer (2000)). This property is particularly appealing for long-term investors such as pension funds, which need to match increases in price levels at the horizon, but not necessarily on a monthly basis. It is possible to select stocks or sectors on the basis of their ability to hedge against inflation (hedging demand), as opposed to selecting them as a function of their outperformance potential (speculative demand). For example, utilities and infrastructures companies typically have revenues that are heavily correlated with inflation, and as a result they tend to provide better-than-average inflation protection.

Similar inflation hedging properties are expected for bond returns. Indeed, bond yields may be decomposed into real yield and expected inflation components. Since expected and realised inflation move together over the long term (see Schotman and Schweitzer (2000)), we expect a positive long-term correlation between bond returns and changes in inflation. In the short term, however, expected inflation may deviate from the actual realised inflation, leading to low or negative correlations. There again, an investor willing and able to relax short-term constraints to focus on long-term inflation-hedging properties will find that investing in nominal bonds can provide a cost-efficient alternative to (or complement to) investing in inflation-linked securities.

Recent academic research has also suggested that alternative forms of investments offer attractive inflation-hedging benefits. Commodity prices, in particular, have been found to be leading indicators of inflation in that they are quick to respond to economy-wide shocks to demand. Commodity prices generally are set in highly competitive auction markets and consequently tend to be more flexible than prices overall. Besides, recent inflation is heavily driven by the increase in commodity prices.

Consistent with these theoretical arguments, a recent study by Gorton and Rouwenhorst (2006) finds that, over the 1959-2004 period, commodity futures were positively correlated with inflation, unexpected inflation, and changes in expected inflation. They also find that inflation correlations tend to increase with the holding period. It has also been found that commercial and residential real estate provide at least a partial hedge against inflation, which implies that portfolios that include real estate allow for enhanced inflation hedging benefits. This effect seems to be particularly significant over long horizons. Hence, Anari and Kolari (2002) examine the long-run impact of inflation on homeowner equity by investigating the relationship between house prices and the prices of non-housing goods and services, rather than return series and inflation rates, and infer that house prices are a stable inflation hedge in the long run.

In new research supported by Morgan Stanley Investment Management, we have used a vector error correction model (VECM) to analyse the joint distribution of asset returns and inflation, and have found that real estate and commodities have particularly attractive inflation-hedging properties over long horizons. Our empirical analysis suggests that explicitly accounting for long-term co-integration relationships leads to significant differences in forecasted properties of asset returns in terms of their term structure of risk and correlations with the liabilities compared to previous studies relying on simple vector auto-regression (VAR).

Our results suggest that novel long-term liability-hedging investment solutions can be designed so as to decrease the cost of inflation insurance from the investor’s perspective. In particular, it is possible to construct enhanced versions of inflation-hedging portfolios including inflation-linked securities, but also commodities and real estate, so as to achieve satisfactory long-term inflation hedging at a lower cost than a solution solely based on inflation swaps.

The intuition behind our results is rather straightforward. The increased expected-return potential generated through the introduction of commodities and real estate in addition to TIPS in the liability-hedging portfolio (LHP) allows for a reduced global allocation to the performance-seeking portfolio (PSP) while meeting the global performance expectations, which in turn allows for better risk-management properties. When the investment horizon is 20 years, enhancing the LHP by the introduction of 5% (respectively 10%) of a real estate plus commodities portfolio leads to a 19% (respectively 39%) reduction in shortfall probability while maintaining the mean funding ratio at the same level as with a LHP purely invested in TIPS. The reduction in severe-shortfall probability is even greater and reaches a spectacular 42% (respectively 78%).

Our analysis of the benefits of alternatives in institutional portfolios can be extended in several directions, and in particular would ideally encompass other forms of alternative investments. While we have focused on real estate and commodities, institutional investors have recently shown an increasing interest in other alternatives such as private equity and infrastructure, for which intuition suggests that attractive inflation-hedging properties could also be obtained. The unavailability of time series for these asset classes with sufficient length and frequency is, however, a serious concern from the econometric perspective. One possible solution would involve the construction of liquid proxies for the returns on these assets based on publicly-traded instruments with similar characteristics, but the adequacy between the proxy and the actual form of investment under consideration (private equity or infrastructure) would have to be carefully assessed.


This article is based on research carried out within the framework of the Morgan Stanley Investment Management ‘Financial Engineering and Global Alternative Portfolios for Institutional Investors’ Research Chair at the EDHEC Risk and Asset Management Research Centre.

 


References
• Anari, A. and J. Kolari (2002). House Prices and Inflation. Real Estate Economics 30 (1), 67-84.
• Boudoukh, J. and M. Richardson (1993). Stock Returns and Inflation: A Long-Horizon Perspective. American Economic Review 83, 1346-1355.
• Campbell, J. and R. Shiller (1988). Stock Prices, Earnings and Expected Dividends. Journal of Finance 43 (3), 661-676.
• Fama, E. (1981). Stock Returns, Real Activity, Inflation, and Money. American Economic Review 71 (4), 545-565.
• Fama, E. and G. Schwert (1977). Asset Returns and Inflation. Journal of Financial Economics 5 (2), 115-146.
• Gorton, G. and K. Rouwenhorst (2006). Facts and Fantasies about Commodities Futures. Financial Analysts Journal 62 (2), 47-68.
• Gultekin, N. (1983). Stock Market Returns and Inflation Forecasts. Journal of Finance 38 (3), 663-673.
• Kaul, G. (1987). Stock Returns and Inflation: The Role of the Monetary Sector. Journal of Financial Economics 18 (2), 253-276.
• Schotman, P. and M. Schweitzer (2000). Horizon Sensitivity of the Inflation Hedge of Stocks. Journal of Empirical Finance 7 (3-4), 301-315.