Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Inflation strategies for the ages
Commodities and active cross-asset ‘trend-based’ strategies should provide the most effective bulwark against entrenched high inflation if history holds true, an award-winning study has found.
Based on almost 100 years of market data from the US, UK and Japan, the paper, titled ‘The best strategies for inflationary times‘, picked up the 2022 Bernstein Fabozzi/Jacobs Levy Awards as the “most innovative and compelling research” published in The Journal of Portfolio Management.
Originally released last August, the study compares the performance of asset classes during extended periods of high inflation (defined as 5 per cent or more) recorded between 1926 and 2020.
While the results back up accepted knowledge, such as the fact that surprise high inflation is good for commodities and bad for bonds, the report offers additional insights.
“Commodities, for example, are a diverse set of assets, and their inflation-hedging properties depend on the individual commodity,” the paper says. “Most importantly, we show that unexpected inflation is very bad news for equities.”
Furthermore, the study says active management – especially trend-based strategies across shares, bonds, currency and commodities – offer an “impressive level of protection” under a sustained high-inflation regime. Factor-based equity portfolios, including tilts to value or quality, can also ward off the worst effects of inflation, the report says.
“Although the average benefit is small (e.g. 3 per cent real returns for a quality strategy to -1 per cent for the value strategy), these factor portfolios perform far better than passive investments in stocks or bonds.”
Real estate (based on US data) proved moderately negative, falling on average by 2 per cent in high inflation times while collectibles – particularly, “art, wine and stamps” – did provide an effective, if barely accessible, store of value during periods of rapidly rising prices.
“Collectibles are unlikely to be part of an institutional portfolio, given the small traded values,” the paper says.
In spite of the limited data series to date, the study also suggests new-fangled crypto-assets such as bitcoin are unlikely to offer much refuge against inflation. According to the report, bitcoin performance trends suggest it operates more as “a speculative asset and has a high beta to US equity returns”.
“Our analysis shows that unexpected high inflation is negatively related to US equity returns,” the study says. “The correlation of US equity and bitcoin returns suggests that bitcoin may not deliver positive real returns in periods of unexpected inflation.”
The paper was authored by four portfolio specialists from the Man hedge fund group – Henry Neville, Teun Draaisma (photo at top), Ben Funnell and Otto van Hemert – along with Professor Campbell Harvey from the Duke University in Durham. Campbell also advises to Man.
