Real Assets: No real growth
In the aftermath of QE, inflation-plus multi-asset funds seemed like an idea whose time had come. Charlotte Moore asks why they failed to catch on
Any graduate of financial theory knows inflation will erode the value of an investment. The long-term nature of pension saving exacerbates the issue: compounding inflation over decades adds up to a very significant problem.
“Pensioners need their fund to generate real returns to provide for retirement, which means that it must grow faster than inflation,” says Johanna Kyrklund, head of multi-asset investments at Schroders Investment Management. “That’s why we decided to make the target for our fund inflation-based rather than cash-based.”
Despite that logic, as Kyrklund’s statement suggests, most absolute return multi-asset funds have cash rather than inflation-based return targets. But some, like Ciaran Mulligan, head of manager research and selection at Buck Global Investment Advisors, say that this is understandable. “An inflation-linked return target could behove the managers of those funds to choose assets with a very specific inflation linkage,” he observes.
Other inflation-plus target funds do exist. Many were developed in the early days of quantitative easing when there were significant concerns that this would cause higher inflation.
Designers of these funds looked for those assets that would respond well if inflation were to rise. And just as a financial theory graduate knows inflation will erode investment value, that graduate also knows the asset with closest relationship to inflation is an index-linked bond.
But there are good reasons why inflation-plus funds do not have 100% of their portfolio invested in index-linked bonds. The combination of falling interest rates, lack of issuance and strong institutional-investor demand has pushed real yields to low or even negative levels over the past few years, all but guaranteeing a real loss of capital if held to maturity.
Berdibek Ahmedov, senior vice-president for real return product at PIMCO, says that, while index-linked bonds have the closest relationship with inflation, his firm’s GIS Inflation Strategy fund also includes commodities and real estate. Furthermore, whereas traditionally a pension scheme would only invest in its domestic index-linked market, the Pimco fund invests globally. “This is a good way to diversify risk and reduce market distortions,” he says.
“When we were designing our Real Asset Portfolio, we looked at historic data to find those assets which had a positive relationship with rising inflation and where that relationship persists over time,” says Patrick Rudden, head of blend strategies at Alliance Bernstein.
The research showed that assets which had a positive correlation with changing inflation included property, commodities and capital-intensive equities. But it also suggested that assets that are sensitive to inflation, taken individually, can deliver lacklustre returns compared with standard equity and bond portfolios. Further research showed, however, that it was possible to combine these assets to give decent inflation sensitivity without sacrificing too much return, if the portfolio was composed of approximately a third commodity futures, a third stocks with high fixed costs and a third listed property.
While specific proportions in each asset class might be the most efficient portfolio design, there has to be a degree of flexibility. Rudden says: “Asset allocation has to be dynamic as valuation of our assets changes.”
Despite their careful design, these inflation-plus funds have failed to gain traction with European pension funds.
As Ahmedov at Pimco reasons: “Inflation is not currently considered a major risk factor in most of Europe so there is less interest in inflation-plus funds.”
It is notable, for example, that Pioneer Investments launched its Inflation Plus fund in 2010 but has since merged with another product
In the institutional pension fund world, the efficacy of the products was especially limited.
Even in those jurisdictions where liabilities are explicitly indexed, such as the Netherlands or the UK, the requirement for assets whose values fluctuate more-or-less in-line with the discount rate applied to those liabilities on a shorter time horizon was not really met by portfolios exposed to a broader set of risks, even if they did promise a longer-term positive real return. For those investors, index-linked bonds and inflation derivatives remain the best solutions.
Nonetheless, there could be greater interest in multi-asset funds in general, and inflation-plus funds specifically, from the defined contribution market.
“Default funds must have robust performance over the very long investment horizon,” notes Will Allport, vice-president for defined contribution at Pimco. “We’ve seen increasing interest in ensuring that a diversified default fund has some allocation to our inflation strategy to protect the overall return in times of heightened inflation.”
But Kyrklund questions whether these strategies would really protect against inflation: “While assets like commodities may act as hedge against certain kinds of inflation, it is quite hard to find assets that will work in every scenario,” she says. The ability of inflation-sensitive assets to work as hedges will be very dependent on their value at the time of any inflation shock, she warns. “If commodities prices are already high at the time of a supply shock their effectiveness as a hedge may be undermined.”
Moreover, inflation is not homogenous. It can be caused by a currency crisis, it can be driven by a spike in commodity prices, such as an energy price shock, it can be demand-driven, and it can come in the form of stagflation. All of these different types of inflation require different responses from a fund manager and assets with an explicit inflation-link may not work in every situation. For example, if inflation is driven by demand then it is equities, not commodities, which will generate the highest returns.
Not only is inflation heterogeneous, it’s also dynamic: just because a particular scenario caused inflation to spike in the past, there is no guarantee that it will do so in the future.
For example, during the Asian crisis in the late 1990s, inflation was the dog that didn’t bark even though currencies devalued sharply.
“If you focus too much on back testing assets for their inflation sensitivities, the danger is that the portfolio construction is too rigid and lacks the flexibility to change as the causes of inflation change and the relationship of different assets to inflation shifts,” says Kyrklund.
“That’s why we take a broader definition rather than simply focusing on those assets that have a proved linked to inflation. As well as investing in those assets that might protect you in a more inflationary environment, we also focus on identifying valuation-based opportunities to enhance returns over time.”
Mulligan concurs: “An absolute return will give you much greater flexibility over the market cycle because you are not confined to only having core assets in the fund that are specifically linked to inflation.”
And, of course, if the core objective of protecting against inflation scenarios is questionable, that makes the prospect of poorer absolute returns all the more worrisome.
“If a pension fund has decided to take the multi-asset route to generate returns greater than inflation with less volatility than investing entirely equities, then why would you narrow your multi-asset universe to those that do not generate sufficient high returns?” Kyrklund concludes.
That seems to have been the conclusion many investors have reached, as well. There may be a strong case for including an inflation-matching bucket as part of a broader multi-asset growth portfolio, but, particularly as real yields on index-linked bonds start to recover, the case for focusing all of one’s growth exposure on apparently inflation-sensitive real assets looks much weaker.