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.
Tuning out the hard assets mantra
The “hard asset mantra” is rising to a fever pitch in an inflationary environment, but investors should be “skeptical of historical analogies.”
Inflation over the coming decade is expected to be closer to the experience of the 2000s than the 2010s, ending a paradigm that has underpinned an “unusually long bull market for stocks” and falling yields for bonds. Navigating that environment won’t be easy, and that’s given rise to the “mantra” that buying real, tangible assets – hard assets – is preferable to so-called financial assets.
The mantra holds that, in an environment where prices are set to rise, investors should be overweight oil, emerging markets, industrial metals and equities, while being underweight equities. But the “conceptual distinction between real or hard assets and financial assets is messy.:
“Equities, for instance, may own tangible, physical assets,” writes Ninety One strategist Sahil Mahtani. “Similarly, a physical gold ETF, or a royalty company, is a claim on underlying physical assets or cash flows resulting from the sale of those physical assets. Meanwhile, financial assets like inflation-protected securities can protect wealth in real terms despite no physical asset backing.”
And with a limited data set of asset class returns at their disposal, investors should be sceptical of “historical analogies”. Inflation-linked bonds used to indicate real rates have only existed since 1981 in some markets, and for an even shorter time in others – but haven’t been around for any period encompassing a major inflationary episode.
“Crucially, it matters what is inflating. In the 1970s inflation episode, high money supply growth interacted with scarce oil resources, exacerbated by wage growth from union intransigence in some countries, lifting inflation expectations in the public,” Mahtani writes. “Today, the drivers of inflation appear to be tilted more towards supply chain disruptions, natural gas more so than oil, and wage growth from shrinking labour force participation.”
“It may also be the case that we are not in a world of ever rising inflation but one of higher inflation volatility. In other words, inflation exhibits large or persistent upside or downside inflation surprises.”
Some parts of the “conventional” answer to the problem also still make sense. While European and US sovereign bonds are highly priced and may not hold their value in an inflationary environment, Asian sovereign bonds could prove attractive given the lower inflation and higher starting yields in that region. Currencies – either commodity price beneficiaries or creditor nation currencies – also represent a “neglected opportunity.”
“But other parts of the ‘real asset’ vs ‘financial asset’ distinction remain dubious. For instance, real estate investment trusts do poorly in an environment of rising inflation break evens,” Mahtani writes. “Given exceptionally high starting valuations globally, not to mention fluctuations in the geographical location of commercial activity driven by the pandemic, it is not clear these should be a cornerstone of inflation protected portfolios.”
“If we are entering a world of above-target inflation for several years to come, investors should ditch the easy answers. Conventional 60-40 type portfolios are likely to struggle, especially those that rely on US and European bonds. Some real assets like real estate and particular commodities may not work. Investors should reflect about what specifically is driving the inflationary process, and invest in equities that have pricing power but are not at frothy valuations.”
