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Inflation hedges: what does and doesn’t work

Surging inflation is one of the nastiest, portfolio-crumbling threats investors face – not least because defending against it is as difficult as defeating dry rot. The last few years have taught us a great deal about what does and does not work, so here’s our updated guide on the best inflation hedges.

Note: All investment returns quoted in this article are annualised real returns.1 

How to hedge against inflation 

There are three asset classes worth considering as inflation hedges:

Individual index-linked gilts

Broad commodities

Gold

A good inflation hedge should:

Respond quickly to high inflation, with correspondingly high nominal returns. 

Work reliably across many different time periods, countries, and inflation regimes.

Deliver reasonable long-term returns over time.

Not a single asset class (including our three prospects above) comfortably fulfils our definition of a ‘good inflation hedge’.

I’ll explain why below.

Sadly, there is no magic bullet answer to the question: “what is the best hedge against inflation?”

Taken together, the top inflation hedges resemble a ragtag crew of mercenary misfits. Sometimes they’ll come through for you: unleashing a spectacular display of inflation-busting pyrotechnics. Other times, they’ll fall on their face like a drunk, trousers round their ankles. An embarrassing mistake. 

These complications mean we believe deliberate inflation-hedging is a less attractive option for early- to mid-stage accumulators than for near-retirees and decumulators.

When you’ve decades to go, concentrate on beating inflation over time with a strong dose of global equities. That makes more sense than hedging against a short-term risk.

As for near-retirees and decumulators, let’s consider which of the reputed inflation hedges you may want on your side.

Inflation hedge: index-linked gilts

If you buy individual index-linked gilts (not index-linked gilt funds or ETFs) then they will hedge against UK inflation provided you hold them until maturity.

For example, if you put £1,000 into the index-linked gilt UKGI 1.25 11/27 – and hold until maturity – then your £1,000 will grow in line with RPI, until your capital (or principal) is returned to you on the bond’s 22 November 2027 maturity date.

On top of that, if you reinvest your RPI-adjusted coupon (interest) payments into the bond, then you’ll approximately earn the current real yield of 0.11% per annum.

That is far from an awesome return. But it’s better than the negative rates inflation-linked bonds were earning until recently.

And at least you know that money invested on this basis will keep pace with inflation.

For Brits, this is the best inflation hedge you can buy in the sense that it will reliably protect your purchasing power against official inflation.

That’s because no other investment is index-linked to a UK inflation measure.

Caveats a go-go

If you sell your individual index-linked gilt2 before maturity then you may make a capital loss (or gain) due to price risk.

Price risk is the risk that the price of your bond drops as its real yield changes before maturity.

If bond yields spike hard and fast enough, then a linker’s price can fall so far that you’re not adequately compensated by the bond’s inflation-linking features.

But – and forgive me for going on about it – bond mechanics mean you can defuse any price risk simply by holding your bond to maturity. (You must also reinvest your coupons in a timely manner to earn the real yield on offer when you bought in, too.)

Price risk is the reason why inflation-linked funds and ETFs are not a guaranteed inflation hedge.

Bond managers typically sell their securities before maturity in order to maintain their fund’s target duration.

As interest rates took off in 2022, managers were therefore booking capital losses as prices fell in response to rising bond yields.

The longer your fund’s duration, the deeper your loss. Short-duration inflation-linked funds were less badly damaged, but they still didn’t keep up with inflation in 2022 and 2023.

For more on how to buy and use individual index-linked gilts, read up on how a rolling linker ladder works and learn how to build an index-linked gilt ladder.

If you maintain part of your portfolio as a ladder of individual index-linked gilts then you can sensibly leave your inflation-hedging efforts at that.

But…

Vanguard points out that index-linked bonds aren’t likely to prop up the rest of your portfolio when the money-munching monster runs amok.

That’s because short-term index-linked bond yields are so slim, that our allocation can’t be expected to do much more than return your money with a few inflation-adjusted sprinkles on top.

(Note, Vanguard talks about US TIPS. But the same is true – perhaps more so – for inflation-linked gilts.)

More concretely, linkers fall short of our ‘deliver reasonable long-term returns’ criteria.

So let’s push on and look at the inflation-hedging properties of commodities.

Inflation hedge: commodities 

Numerous research papers point out that commodities sometimes deliver exceptional returns in the teeth of inflationary pressure.

It certainly makes sense that commodities should serve as some kind of inflation hedge, given that the cost of raw materials is often one of the booster rockets strapped to accelerating prices.

That said, most of the research examining the issue is problematic. Usually because the data doesn’t reflect investable commodity indexes, or is quite short-term, or is US-oriented, and so on.

Nonetheless, your heroic Monevator correspondent partially mitigated his own cost-of-living issues by spending time digging up relevant broad commodities data and plotting it against UK inflation – instead of blowing his cash on having a life. You’re welcome.

My conclusion?

Commodities are a partial inflation hedge.

The asset class has delivered spectacular returns at times as inflation begins to stir.

Often the lift-off in commodities presages escalating UK inflation further down the road.

But by the time headline rates are hurting our pockets, commodity prices are often tumbling back down again.

Over a one-year period, commodities are actually negatively correlated with UK inflation (1934 to 2022).

However, commodities outdid the other major asset classes when inflation was above-average (1934 to 2022).

Average annualised returns during inflationary episodes were:

Commodities: 4.5%

UK equities: 3.6%

Gold: 1.8%

Gilts: -2.2%

Cash: -1.9%

Meanwhile, the historic annualised real return of commodities was 4.5% (in GBP) across the entire time period from 1934 to 2022.

Thus an allocation to raw materials historically fulfilled the ‘deliver reasonable long-term returns’ part of the brief.

And they have generated extremely high, inflation-beating nominal returns at times.

But commodities cannot be said to work reliably as an inflation hedge. You can shape them around your portfolio like an armoured plate, but you can’t expect them to deflect every inflationary bullet.

Finally, the USP of commodities is also its biggest weakness.

Commodities are useful primarily because they’ve been historically negatively correlated with equities and bonds. And equities and bonds tend to fail together during bouts of galloping inflation.

But commodities can be a terrible drag when the commodity asset class suffers a bear market. The beating taken by commodities between 2008 to 2020 would have shaken the resolve of even the most fanatical inflation-phobe.

We recommend reading the recent Monevator commodities series and researching the asset class yourself before committing any cash.

Inflation hedge: gold

The case for gold as an inflation hedge is similar to – but weaker than for – commodities.

At best, gold’s performance can only be appropriately measured from 1968. That’s because it was caged by government regulation before then.

Monevator investigated the behaviour of gold versus UK inflation when we asked: is gold a good investment?

The long and the short of it is that gold is historically uncorrelated to inflation. You can’t rely on the yellow metal as an inflation hedge.

So why are we even talking about gold? Because it is also negatively correlated with equities and gilts. So occasionally the shiny stuff’s good years have coincided with bouts of unexpected inflation.

Gold just bobbed ahead of inflation in 2022 and 2023. It also had a reasonable 1970s during that stagflationary era.

Golden years

The US-orientated, 2021 research paper The Best Strategies For Inflationary Times stated that gold turned in average returns of 13% during four inflationary regimes post-1971.

But the paper’s authors then break our hopeful hearts by warning:

Looking at averages over all regimes could be misleading because of one influential regime. For example, Erb and Harvey (2013) show that gold’s seeming ability to hedge unexpected inflation is driven by a single observation.

And here is that single observation. The gold price shot up near 200% in 1980:

Source: Claude Erb and Campbell Harvey. The Golden Dilemma. 2013. Page 9.

Even Erb and Harvey say of gold’s relationship with unexpected inflation:

There is effectively no correlation here. Any observed positive relationship is driven by a single year, 1980.

Meanwhile, the long-term GBP annualised returns of gold are hard to pin down. Take your pick from:

1900-2022: 0.8%

1968-2022: 3.5%

1975-2022: 1.5%

Ultimately, gold is a total wildcard.

It may work during an inflationary crisis: the charts show it soaring like a NYC pencil-tower during some years in the 1970s.  

You’d always want gold in your portfolio if you could rely on it doing that.

But then again, gold suffered a 19-year horror show from 1980 to 1999. Losses peaked at -78%. 

Accumulators can happily skip the quandary. Decumulators who want to ward off sequence of returns risk may want to use gold sparingly as disaster insurance. 

But the case for gold as an inflation hedge is weak. 

Inflation hedge: real estate

Property is often named on the roster of potential inflation hedges. However, the renowned investment researchers Dimson, Marsh, and Staunton found that commercial real estate returns are negatively impacted by high inflation, though less so than broad equities. 

However, that could be an artefact of sluggish property prices. In other words, the inflation effect is simply delayed in comparison to liquid equity markets. 

Because REITs have reasonable long-term returns but a negative relationship with inflation, we think commercial property is best thought of as an inflation-beating strategy. As opposed to an inflation hedge. 

Dimson, Marsh, and Staunton tentatively suggest that residential property is quite resistant to inflation. But returns still have a negative relationship with high prices.

However the verdict in The Best Strategies For Inflationary Times is a little more encouraging. 

UK residential property delivered a 1% average return during high inflation periods. Returns were positive in 57% of the 14 periods examined between 1926 and 2020. 

Incredibly, Japanese residential property delivered 12% average returns with a 100% positive return across six high inflation episodes from 1926 to 2020. 

But US residential property returns were -2% during inflationary bouts. It only mounted a positive response a quarter of the time.

Location, location, location

Keep in mind that unique factors could be at play in each of these markets.

And we also can’t ignore the fact that historical records of property prices are notoriously problematic.

Long-term data typically fails to capture high-resolution details such as ownership costs, rental assumptions, taxes, default risks, transaction costs, and illiquidity.

You have to put a peg on your nose every time you lend credence to historical property returns.

UK homeowners conditioned by a 30-year property bull market have long thought of their castles as a bastion against inflation.

And residential property did deliver a positive return in two out of three episodes during the ‘70s, according to The Best Strategies For Inflationary Times

But that’s little comfort for anyone struggling to get on the housing ladder.

Moreover, it’s difficult to diversify residential risks.

Even a portfolio of rental properties is prey to local market conditions. These can swamp any inflation effect.

Inflation hedge: stocks and equity sectors

Can individual stocks or sectors serve up inflation hedging salvation where the broad equity market cannot? 

Dimson, Marsh, and Staunton sound dubious: 

It is tough to find individual equities, or classes of equities, or sectors that are reliable as hedges against inflation, whether the focus is on utilities, infrastructure, REITs, stocks with low inflation betas, or other attributes.

Meanwhile, Neville et al investigate the performance of 12 US stock sectors in The Best Strategies For Inflationary Times. Every sector except energy stocks posted negative returns during high inflation periods. 

The energy sector did manage a 1% average return during those periods. But the return was only positive 50% of the time.

Notably, average returns were -19% during the 1972-74 recession that was infamously fuelled by the OPEC oil embargo. 

Ultimately, equity prices are subject to a swirl of forces beyond inflation. These can confound a simple thesis such as ‘high oil prices must be good for oil firms’. 

Looking for the X factor

Three other equity sub-asset classes posted positive returns during high inflation regimes according to Neville et al. These were three of the risk factors:

Momentum

Quality

Investment

Momentum looks especially hopeful, with 8% average returns and positive returns in three-quarters of the scenarios considered in The Best Strategies For Inflationary Times.

The snag is these compelling results tested the ‘long-short’ version of cross-sectional momentum.

But us ordinary UK investors can only access long-only momentum ETFs. Which offer a diluted version of the pure form examined in the paper. 

Once again our hopes are stymied by the gap between backtested theory and investible reality. 

The authors also say they’re cautious about momentum’s results, due to its low statistical significance and its sensitivity to their chosen dates:

For example, January 1975 was a very negative month for cross-sectional momentum, and our inflationary regime stops in December 1974. Equally, late 2008 through early 2009 was catastrophic for momentum, and our inflationary period ends in July 2008.

However, the authors do make encouraging observations about the benefit of straightforward international equity diversification:

Equities really only struggle when two or more countries are suffering. This is consistent with a global bout of inflation being very negative for equity markets. 

The results also suggest benefits to international diversification. For example, taking the UK perspective, US and Japanese equities generate +6% and +9% real annualized returns during UK inflation regimes, respectively.

This is perhaps one of the drivers behind the large international equity allocations run by some of the major UK pension funds coming out of the inflationary 1970s and 80s.

Inflation-hedge: timberland

Timberland enthusiasts describe it as the dream package. Who wouldn’t want an inflation hedge that offers good risk-adjusted returns, plus low correlations with equities and bonds?

But even fund managers selling timber investments confess the asset class has been a moderate inflation hedge at best.

Alternative investment firm Domain Capital states:

Timber has been found to be positively correlated with unanticipated inflation. During periods of high inflation, as in the 1970s, timber provided a partial inflation hedge. With a correlation of 0.34 to inflation during the 1970s, timber prices tended to outpace unexpectedly high inflation. 

Here’s a recap of how correlation metrics work:

1 = Perfect positive correlation: when one thing goes up so does the other

0 = Zero correlation: the two things being measured have no influence upon each other 

-1 = Perfect negative correlation: when one thing goes up, the other goes down

A correlation of 0.34 during the stagflationary 1970s is not great.

The timberland / inflation correlation then drops to 0.29 between 2003 to 2017. 

Between 1987 and 2010, the correlation was 0.64 according to Barclays Global Inflation-Linked Products – A User’s Guide.

That compares with inflation correlations of 0.80 to commodities and 0.84 to short-term index-linked gilts.

But the even bigger problem I encountered when trying to stand up timberland is that sources tend to use data from the NCREIF Timberland Index. 

This US index has two main issues:

It only tracks timberland’s performance from 1987. That’s a pretty short timescale. Especially given that – until recent years – inflation had been quite benign since the late 1980s.  

The index is dominated by private equity companies that invest in timber and forestry. Those companies are inaccessible to retail investors like us. 

Instead, we can invest in publicly-traded timber REITs and forest product companies.

Barking up the wrong tree

The S&P Global Timber & Forestry Index is the most popular index covering public timberland firms. 

You can gain exposure to it via an iShares ETF with the ticker WOOD. (See what they did there?)

But we’re stumped again! Public timber stocks are much less effective inflation hedges than their private equity brethren, according to the paper Assessing the Inflation Hedging Ability of Timberland Assets in the United States.

Its authors concluded:

Private-equity timberland assets can hedge both expected and unexpected inflation, and the ability becomes stronger as the investment time increases.

In contrast, public-equity timberland asset is not effective in hedging either.

As for timberland’s diversification benefits, they say:

​​In summary, private-equity timberland assets have a negative correlation with the market and are a good hedge against actual inflation.

On the other hand, public-equity timberland assets behave more like common stocks and have a high correlation with the market.

The study covers the period 1987 through 2009. But it chimes with my anecdotal experience of keeping an eye on iShares’ WOOD. 

WOOD’s returns have been closely correlated to MSCI World ETFs. Ultimately, I’ve not been able to justify branching out into timber. [Ed – fired!

Inflation hedge: trend following

Trend-following scored average returns of 25% in inflationary periods according to The Best Strategies For Inflationary Times. It also worked reliably in all eight scenarios. 

Returns for the entire 1926 to 2020 period were an astounding 16%.

At this point, I wish I knew how to execute a proprietary trend-following strategy using futures and forwards contracts associated with commodities, currency, bond, and equity prices.

Because that’s what the authors backtested.

They name check their methodology. But I’d guess this strategy is beyond the ken of most people.

Other inflation hedges  

Our final inflation hedging candidates are collectibles: wine, art and stamps.

The Best Strategies For Inflationary Times suggests they have game:

Collectible
Inflation episode average return (%)
Anti-inflation reliability (%)

Wine
5
50

Art
7
63

Stamps
9
75

But once again the academics are building a case on an index you can’t invest in. The underlying data ignores transaction fees, storage, and insurance costs. All of which would chomp down those returns. 

Moreover the average punter is going to struggle to put together a diverse basket of Old Masters. 

Right now there’s no ETF tracking the market for Picassos, Warhols, and Cézannes. 

If you can profitably swim in those waters then the best of luck to you. But hopefully you’re not just sticking this treasure in a vault for the purpose of inflation hedging. 

The Investor covered some of the pitfalls of investing in illiquid and opaque markets in his piece on alternative asset classes.

Beating inflation

So where does that leave us, except more disillusioned than ever? 

As previously stated, because inflation hedging is so problematic I’d skip it if I was still an accumulator saving for retirement. I’d rely on straightforward global equities to beat inflation instead. 

But decumulators and retirees are highly vulnerable to unexpected inflation. 

The most reliable buy-and-hold method to hedge inflation is to create a ladder of individual index-linked gilts. 

You might also consider an allocation to broad commodities and even gold as modelled in our decumulation strategy portfolio.

Hedging your hedging bets

You may consider inflation to be such a threat that it justifies a small percentage to each of the assets we’ve covered. This way you have a diversified hedge against inflation. 

Is it worth it? Only you can decide what’s right for you. 

I’ll give the last word to Dimson, Staunton, and Marsh. Their peerless work acts as a shining light for us ordinary investors in search of answers:

Inflation protection has a cost in terms of lower expected returns. While an inflation-protected portfolio may perform better when there is a shock to the general price level, during periods of disinflation or deflation such a portfolio can be expected to under-perform.

Take it steady,

The Accumulator

Annualised is the average annual return accounting for gains and losses. Real return is the amount the investment grows (or shrinks) over a period after inflation is stripped out.Colloquially known as a ‘linker’.

The post Inflation hedges: what does and doesn’t work appeared first on Monevator.

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