A close look reveals that not all real assets are so real.
For the last three decades, the policies of central banks have kept inflation relatively stable. But this has not always been the case. For example, the 1930s saw deflation, or negative inflation, that devastated industry and agriculture, while the 1970s saw sustained high inflation diminish the standard of living. For investors, inflation erodes purchasing power and undermines the funding of future goals. And while financial markets generally do a good job of pricing assets for expected inflation, unexpected inflation remains a risk.
Investors commonly turn to real assets – the so-called hard assets of real estate, infrastructure and natural resources – to mitigate this risk as well as for portfolio diversification. But are they really an effective inflation hedge? And if so, which are the most reliable?
To answer these questions, Peter Mladina, director of portfolio research for Northern Trust Wealth Management, and Joe Bates, a senior analyst on his team, performed statistical analysis on 20 years of historical data. In addition to evaluating real estate, infrastructure and natural resources, they also looked at Treasury Inflation Protected Securities (TIPS), which investors also commonly use to protect against inflation.
Inflation Can Erode Purchasing Power1
Bond Returns During the High Inflationary Environment of 1973-1982
As it turns out, their findings show that not all real assets are so real, at least when considering inflation sensitivity. Specifically, their research, presented in How Real Are Real Assets?, suggests the following:
- REITs and infrastructure are likely not reliable inflation hedges. Perhaps counter to conventional wisdom, public infrastructure and real estate investment trusts (REITs) show no reliable inflation sensitivities.
- Private real estate might help mitigate inflation. The asset class demonstrates inflation sensitivity, but the result could be due to how the underlying assets have been priced (i.e., appraisal-based), as the results are inconsistent with those of REITs, which own fundamentally the same underlying assets.
- Natural resources equities are likely one of the best tools for protecting against inflation. Both natural resources and commodities show a strong sensitivity to inflation. However, while both fare similarly on this measure, equity-based natural resources demonstrate a more favorable risk/reward profile relative to commodities.
- TIPS are the only true inflation hedge for investors with multi-year financial goals. Statistically, TIPS demonstrate a positive though relatively moderate sensitivity to inflation. But these results are likely skewed by the near-deflationary environment of the 2008-2009 global financial crisis and are limited by a lack of longer-term data.
In practice, TIPS are structurally indexed to inflation; the principal of a TIPS bond adjusts annually in line with upward or downward changes in inflation. And as the team demonstrated with another research analysis, “Risk-free” Goal Funding,” this inflation adjustment effectively guarantees that TIPS hedge inflation for investors who align them to fund multi-year financial goals, such as lifetime consumption.
These findings provide useful, broadly applicable insight, as unexpected inflation can undermine the successful funding of future goals. While the role of real assets is to both diversify and mitigate inflation risk, TIPS and natural resources may be your best tools when it comes to the latter.
- Source Ibbotson. *Low duration represented by 50% Intermediate Term Government and 50% Treasury Bills with constant rebalancing. **The maximum real drawdown is defined as the maximum decline from beginning value based on the inflationary period after adjusting for inflation and is a measure of the loss of purchasing power. Past performance is not indicative of or a guarantee of future results, which will fluctuate as market and economic conditions change.