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The inflation factor: how to cut your hedge to suit your portfolio

Gold, commodities and real estate are among the asset classes that investors should consider as hedges against inflation, but knowing when to get out is key.
The inflation factor: how to cut your hedge to suit your portfolio

Asset owners should consider increasing their exposure to inflation-hedging assets but must be mindful of the risks of doing so, experts have told AsianInvestor.

While the US Federal Reserve and many analysts expect inflationary pressure to be transitory – a side-effect of the recovery from Covid-19 – a wrong call on rising consumer prices could prove extremely costly to investor portfolios.

Record inflows into inflation-linked US Treasuries (Tips) last week suggested that investors were already heeding the call to protect themselves against what could prove to be an enduring spell of higher prices.

During periods of elevated or accelerated inflation, it made sense for asset owners to consider including inflation-sensitive assets such as gold, commodities, natural resource equities and real estate in their portfolios, according to advisory company Willis Towers Watson (WTW).

Paul Colwell, WTW

While the firm takes the view that inflation is likely to be contained over the next 3-5 years, “there is a wide range around that which could lead to some potentially disruptive outcomes,” said Paul Colwell, its head of the advisory portfolio group for Asia.

He said that many Asian investors still don't have much exposure to inflation-sensitive assets, so there was continuing scope to increase some of these in their portfolios.

Asset management firm Schroders, meanwhile, believes the US dollar could play a hedging role.

"Given the divergence in central bank policies, we believe it makes sense to go long in US dollars against the euro. We also expect the Chinese yuan to be range-bound given the macroprudential policies of the government,” said Chloe Shea, associate investment director at the firm.

David Chao, global market strategist for Asia Pacific (ex-Japan) at Invesco said he thought Tips, real estate and developed market cyclical equities were good assets to include in a portfolio if major central banks maintain loose monetary policies.

However, he warned investors should weigh their risk-reward profile and remember their liquidity needs when adding inflation-hedged assets. “Diversifying to inflation-hedged, but relatively illiquid assets such as infrastructure and real estate, could be problematic for some investors,” he told AsianInvestor.

KEEPING PORTFOLIOS DYNAMIC

When adapting their portfolios to inflation, investors should adopt a dynamic approach rather than make long-term strategic asset allocation changes, warned Colwell. This is because inflation-sensitive assets tend to also be sensitive to the macro-economic cycle, he said.

“Long-term real returns [of these asset classes] haven't been fantastic over significant periods of time relative to, say, equities and bond portfolios,” he said.

Furthermore, based on data from past inflation regimes, each asset class has its trade-offs. For example, while gold is highly sensitive to inflation, making it a good hedge, the consultant gave it a “medium” score in terms of reliability, or the extent to which the inflation hedge works over time. 

However, asset owners may face several constraints on their ability to maintain dynamic portfolio allocations and make changes quickly in response to evolving macro conditions, he said.

Governance and decision-making processes or timelines affect how quickly investors can make asset allocation changes. “Additionally, the level of delegation to management teams is often tightly controlled,” said Colwell.

It can also take time for asset owners to find an appropriate vehicle to execute their desired strategy, or to carry out the due diligence needed to select an external investment manager for the allocation.

Michael Enriquez, Sun Life

He said institutional investors wishing to make allocations to inflation-sensitive asset classes - especially those without previous exposure - may need to educate stakeholders of the merits of the new allocation and then seek necessary board and committee approvals, Colwell added.

For insurance companies, there was the further need to consider solvency and risk-based capital regulations, he said.

Indeed, this emerged as one of the key concerns for Sun Life Philippines.

“We have enough flexibility within the set guidelines, but we don’t normally significantly deviate as we always consider asset-liability matching,” Sun Life Philippines president and CIO Michael Enriquez told AsianInvestor.

 “What we have been doing [instead] is to find suitable credits to improve the yield of the portfolios,” Enriquez said, adding he believed the inflation spike in the Philippines was transitory as it had already been easing since May.

Inflation rates currently pose a large amount of risk to financial assets, Sue Brake, chief investment officer of Future Fund in Australia told AsianInvestor in an exclusive interview last month.

She added that the fund has relied on flexibility since the pandemic hit to adapt to the changing situations and sidestep equity market risks. 

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