Few aspects of investing are as certain as the fact that portfolio returns will be impacted by inflation. Price appreciation is embedded in our financial system. Central banks have an interest in shielding their economies from extended periods of deflation and a commitment to containing consumer price fluctuations within a fixed range. Within the EU, this policy almost guarantees the average cost of living will appreciate by 2% or more per annum.
Inflation-linked government securities, such as the U.K. government’s index-linked gilts, offer one fairly straightforward way to isolate the impact of inflation. However, with government bond yields at record lows, the opportunity cost of holding gilts can be high.
As part of Morningstar’s Inflation Focus, we discuss three other strategies to inflation-protect an investment portfolio. While these are oft-cited anti-inflation tools, understanding their relationship to an investor’s risk tolerance, time horizon and broader financial goals can be far from simple. To help us gain insight into how inflation and investment goals can be reconciled, we spoke to three experienced financial advisers.
Grasping the Big Picture
Every portfolio needs inflation protection, but to what extent and in what manner differs investor by investor. One of the key factors will be the investor’s time horizon.
“Inflation risk is measured by the life of the portfolio being considered,” agrees Peter Sudlow, principle at Sapienter Wealth Management. For example, an investor approaching retirement and looking to take advantage of an income drawdown pension plan will seek income in the short, medium and long term. This requirement will not only determine the allocation of assets within the portfolio but also the inflation protection tools employed. Such investors will also have to consider both short term and long term inflation, whereas an investor with a long-term horizon need only worry about the latter.
With an immediate and ongoing need for income, a pension income drawdown portfolio would typically contain a cash segment to ensure immediate access to income, a short-term global bonds segment to ensure short- to medium-term access to income, and an equity segment to be held long term. As the investor draws nearer to their investment horizon, assets would be relocated away from the long-term equities portion of the portfolio towards the more immediate income-producing portions.
To Bond or Not to Bond
Dennis Hall, founder of Yellowtail Financial Planning, utilises both index-linked gilts and short-term bonds to protect his clients’ portfolios from inflation. The decision to adjust exposure to either being the result of his assessment of that asset’s ability to provide an inflation hedge combined with its relative risk/reward profile and suitability to each client. Short-term bonds, Hall says, can provide investors with what he calls “insurance within a portfolio”--isolating market risk, while at the same time seeking to limit the impact of inflation. Due to the short length of these products’ coupons, the fixed return on short-term bonds will be subject to inflationary pressure over a shorter period of time, thus leading to less income erosion. Long-term bonds, while a bargain in the 2008/2009 market crash, are now pretty much gone from the portfolios Hall manages due to the excessive risk in this sector of the market.
Stuart Fowler, director at Fowler Dew Limited, however, takes a somewhat different view on the utility of bonds in a portfolio. “Bonds represent unrewarded inflation risk”, says Fowler. While he acknowledges the role of index-linked gilts as a short-term inflation hedge, taking further exposure to fixed income in his view is simply substituting market risk for inflation risk and is therefore unjustified.
Though bonds can smooth out portfolio returns in the short to medium term, Fowler argues that eliminating volatility is an often misguided investment goal. In the current market, exposure to bonds can limit the volatility of portfolio returns, but it can also harm the portfolio’s return in the long term, given that bond yields are at historic lows. Therefore, Fowler argues that unless an investor is more sensitive to market volatility than to inflation risk, “you can never argue that bonds reduce your risk.”
Equities as an Inflation Hedge
The only tools in Fowler’s inflation-fighting toolkit are index-linked gilts and equities. When investing for the long term, Fowler suggests that investors ask themselves “Am I buying into something that has the power to adapt and survive?” The answer to this question leads him to high equity exposure for long-term investing.
All three IFAs adjust project equity returns for inflation. Fowler, for example, combines historical real total returns data adjusted for inflation with macroeconomic analysis, which aims to show where in the business cycle markets are and if they are moving above or below the historic trend.
Hall is in agreement: those with a long investment horizon can afford to take on more equity risk. Over an extended period of time, equity investors can both ride out the peak and troughs of the market and potentially beat inflation, something which cannot be guaranteed on year-by-year basis.
Sudlow also advocates that long term investors use equities to ride out both market fluctuations and inflation risk. Within equities, Sudlow favours passively-managed funds such as ETFs offering exposure to global markets, small caps and value companies. He fully subscribes to the view that equity investing is the best long-term hedge against inflation, but expresses reservations as to the utility of active management. Instead of attempting to “second guess” the market, Sudlow prefers to track market returns and compensate losses due to tracking error or investment fees by gaining some exposure to high-risk, high-return assets such as smaller and distressed companies. Sudlow tops this up with exposure to global bonds within the fixed income portion of his portfolios.
On a final note, as investors with shorter time horizons can also see the value of their assets eroded by currency fluctuations in addition to short-term inflation, Sudlow recommends such investors would benefit from a local-currency portfolio bias.
En Fin
All said, this goes to reiterate that in tackling inflation, as in tackling broader investment risk, investors would be best served by creating a long-term portfolio. Even new retirees are potentially facing a treble-decade investment horizon. All three advisers agree that with such horizon in mind, exposure to equities is the best bet against soaring prices, though additional fixed income products can provide short-term protection and income, as well as volatility management and the peace of mind of predictability.
Fighting inflation in the long run will likely be just one of many investment goals. Selecting the right asset allocation is thus a result of setting time horizons, realistic total return expectations and broader personal circumstances. For example, whether or not you own property or receive property rents can have a significant impact on both your exposure to inflation and your total return outlook. This is why allocating assets, even to standard inflation-fighting tools, is a choice based on the broader risk-return profile of these assets and their correlation to the behaviour of the rest of your portfolio.
