Advisors have several options to help clients who want to add an inflation-hedging component to their portfolios. Investments in Treasury Inflation Protected Securities (TIPS) or stocks involved in natural resources, infrastructure and real estate may all be appropriate. But implementing an effective inflation-hedging strategy involves targeting a time frame that may provide the potential for inflation protection, and then examining how specific strategies are constructed to help avoid hidden or uncompensated risks.
HERE ARE IMPORTANT CONSIDERATIONS WHEN SEEKING TO HEDGE INFLATION EXPOSURE ACROSS THREE TIME FRAMES:
TIPS can be a good option for investors seeking a hedge against unexpected changes in near-term inflation. Interest on these fixed-income securities is tied to the Consumer Price Index for Urban Consumers. If inflation rises suddenly, the income stream on TIPS will rise accordingly. However, this benefit comes with a challenge: Managing the duration of a TIPS strategy.
Duration, is a key measure of a bond’s sensitivity to interest rate changes, and TIPS’ durations can change frequently with changing inflation expectations. The reason for this is future cash flows, a key determinant of duration, are driven by inflation expectations. If inflation expectations rise or fall, expected future coupons adjust accordingly. For example, a TIPS strategy with a duration of 5 years may see its duration rise if inflation expectations fall—increasing the interest rate risk in a client’s portfolio.
To help address the potential of duration drift when using TIPS:
Economic expansions can trigger inflation over longer periods, such as 5 to 20 years. In expansionary economies, investments in natural resources-related companies historically have offered a measure of protection against inflation: When demand is high, the price of raw materials in sectors such as energy, agriculture, metals, timber and water may rise too.
However, these potential inflation-hedging characteristics tend to be more pronounced in the upstream portion of the natural resources supply chain—where companies are harvesting or extracting the resources that are in high demand. Earnings, revenues and cash flow for upstream companies are more correlated to the price of raw materials compared to downstream companies that tend to have higher costs for purchasing, shipping and processing those materials into finished goods.
Consider these features when looking for a natural resources strategy:
Exposure to real estate and infrastructure companies traditionally has been useful for investors concerned about the impact of long-term inflation. Real Estate Investment Trusts (REITs) may offer the potential for long-term protection because the value of their properties and rent payments have been shown to increase with rising prices. Similarly, infrastructure companies often operate in regulated markets and can pass cost increases on to customers.
When investing in either asset class, though, diversification is critical in seeking to reduce the risk of unintended concentration in specific regions or sectors. For example, many real estate strategies invest only in U.S. REITs, which tend to be more volatile than international REITs. Sector concentration risk is a concern in traditional infrastructure strategies. These tend to be heavily invested in sectors such as pipelines and utilities, making them overly sensitive to energy prices.
To help ensure a REIT or infrastructure investment is properly diversified:
Reviewing inflation concerns with your clients can help you target appropriate strategies that match their time frame and complement other investments in their portfolios.
For more on FlexShares’ approach to inflation-hedging strategies, see our Fund pages on FlexShares.com:
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