There are several multi-asset funds mandated to match or beat inflation. Martin Steward asks whether they are anything more than re-packaged absolute return products
Here is a simple question: What does an inflation-proofed portfolio look like? The simple answer: 100% inflation-linked bonds. Held to maturity, that would be the right answer, too. But mark-to-market, basis risk can be high. Particularly when inflation spikes, nominal yields can drag up real yields. If that matters, your other choice is rolling exposure at the very short-end of the yield curve.
"Short-term bonds are an excellent proxy for actual inflation," says Adam Patti, CEO of IndexIQ in Rye Brook, NY, which researched the drivers of global inflation since 1910 before launching its IQ CPI Inflation Hedged ETF of ETFs. "The challenge is to drive your real return above that." The IndexIQ fund aims to deliver US CPI+2-3% every year, and to do so it can move out of short-term bonds into 18 other asset classes. But are those the usual suspects - inflation-linked bonds, commodities, resource-related equities? Not necessarily. "Most if not all asset classes have some level of inflation protection embedded in their returns," says Patti.
That makes sense. Anything that is not a current or nominal asset is a real asset. Antoinette Eltz, real return product manager at PIMCO responsible for its All Asset fund, targeting US RPI+4% over the business cycle, says: "Every asset class should provide a return in excess of inflation over the long term. Over longer periods, a 60/40 bonds mix should return inflation+1-2%."
At Pioneer Investments, the newly-launched Inflation Plus fund aims to outperform the eurozone's Harmonised Index of Consumer Prices over three-year rolling periods. Given that inflation can be demand, supply, policy or wage-driven, and the long-term rolling return target, "we have to be able to access as many asset classes as possible," says Christian Frischauf, senior portfolio manager at Pioneer Investments.
It is perhaps significant that the product comes from Pioneer's total return team. The suspicion that these ‘inflation' portfolios are just diversified absolute return funds is strongest with Pioneer's product. Its core portfolio is short-term money markets and inflation-linked bonds (both inflation-related); but can also hold 10-year government bonds and corporate credit (up to 25%). How are nominal assets justified in an inflation portfolio? They are traded long/short. "It's not so much beta as alpha," explains Frischauf.
The satellite portfolio is in diversified real assets: as the inflation cycle matures, the portfolio moves into equities (up to 30%), REITs (up to 10%), high-yield bonds (up to 10%), and industrial, energy and agricultural commodities (up to 40%). But even here, the focus is alpha. Its bottom-up stockpicking shows no systematic real asset bias - "We just have the best stocks," says Frischauf - while commodities exposure will mix the firm's existing inventory-cycle alpha strategy with tactical plays on individual ETCs. Even more striking is the dynamic allocation between core and satellite portfolios. A minimum of 50% must be in the core, but otherwise the allocation fluctuates because, as inflation moving averages (and therefore the return hurdle) falls, the portfolio risk budget falls. The effect in a deflationary cycle would be significant. "If it works as anticipated it will force us into government bonds," says Frischauf. Like any good diversified fund, as inflation falls and interest rates follow, it takes on duration - and tracking error against inflation increases. The challenge is not getting caught by an inflation spike when the portfolio is calibrated for an inflation trough.
The PIMCO All Asset fund takes its asset allocation from sub-advisor Research Affiliates, implemented via PIMCO strategies. These include US Bond Strategies (currently about 30% of the portfolio), but also short-term strategies, alternative strategies, equity strategies and explicit inflation-related strategies (inflation-linked bonds, real estate, commodities). Equity strategies are limited to broad regional indices (with no explicit real-asset bias); commodities exposure is passive, using the firm's ‘double real' approach to collateralising futures with inflation-linked bonds or enhanced cash. "We are strong believers in the inflation-protection capabilities of commodities, especially against unexpected surprises in inflation," says Eltz.
Unlike standard diversified growth funds, asset allocation is systematic and based on relative value between current inflation-adjusted real yields and expected growth in real yields - not nominal yields. One might expect that to push the portfolio into real assets - but the risk is that a market fearing inflation could push down the real discount rate, making the expected real return from nominal bonds look more attractive than that from inflation-linked assets. This may be why, in the face of inflation fears and falling real yields, the strategy has recently put more into US Bond Strategies than Inflation-Related Strategies. Again, while this relative value judgment might make sense from an absolute return perspective, it could make the portfolio vulnerable to an inflation spike. The US strategy has delivered on its target for eight years - but those were the days of the Great Moderation. "If we were wrong [to judge that the market was overpaying for inflation protection] and we saw inflation spike, we would wish that we had more in inflation assets," Eltz confirms. "But we would also hope and expect that, since an inflation spike may happen rapidly, but not overnight, we could adjust as the surge began."
Patrick Rudden, senior portfolio manager at AllianceBernstein, is unequivocal about its Real Asset fund, due for launch in March and aiming for a CPI+3-5% return. "If inflation surprises on the upside, you'll be pleased that you have it," he says. "If we don't get inflation you won't be so pleased. But you don't insure your house because you want it to burn down."
It is at the height of a hot, dry summer that insurance will be expensive. Strategies like PIMCO's save on premiums, but may leave property vulnerable. AllianceBernstein's tries to get the best value with a multi-asset portfolio balancing "the reliability of performance when inflation surprises and the opportunity costs", but, as its name suggests, it will be made up of commodity futures, REITs, inflation-linked bonds, energy and other natural-resource equities, and possibly gold bullion and FX positions. That feels like a common sense portfolio for inflation: equity exposure is exclusively real-asset related; and while the commodity strategy is active, it will be collateralised with inflation-linked bonds, and focused on long positions in backwardated commodities and zero-weighted or short positions in those in contango. (Rudden notes that "while in the long-run there has been no real return associated with commodity futures, the roll return has been positive, and it has been positively-correlated with inflation".)
AllianceBernstein starts with empirical research into the key drivers of historical inflation. As we have seen, IndexIQ's ETF does the same, but goes a step further - it takes the monthly US government CPI result and runs regressions to find the best-fit asset mix for that rate of inflation, plus 2-3%. Patti is confident that this will enable the fund to deliver on that target annually, not just longer term.
The fund can invest in equities, real estate, oil, gold and FX positions but, launched into a low-inflation environment, it is currently 81% in short-term bonds, 9% in long-term bonds, 5% in a gold ETF and 4% in a Japanese yen ETF. "As inflation increases, the short and long-term bond component reduces," says Patti. But it is interesting to see fairly high weightings to gold and FX already - Patti says that even in 10%+ inflation spikes gold has only gone to about 6% in backtesting - as this suggests that the regressions are picking up (and hedging) the monetary nature of current US CPI, even as the broader inflation environment seems subdued.
Both IndexIQ and AllianceBernstein say they can apply the research behind their US products to UK and euro-zone inflation. PIMCO, whose US fund manages no less than €15bn, has a more recently-launched UK version, but found little interest for a euro-zone version some years ago.
However, for investors with inflation-linked liabilities, the more important question might be about how resilient these products are against inflation shocks. There are funds offering true optionality on these surprises - Universa Investments' Black Swan Protection Protocol-Inflation, for example, or the similar Cullinan fund run by 36 South Investment Managers - but those looking for multi-asset portfolios to do the same may want to look for asset allocation that has an empirical basis in inflation drivers, rather than an ambition to beat long-run inflation with an absolute return.