Inflation Risk and Real Return

Abstract:     
Inflation risk is greatest in times of national or global stress; inflation risk is a form of a “tail risk.” A traditional portfolio of stocks and bonds is exposed to inflation risk. The specific nature of an investor’s liabilities and spending determines inflation sensitivity beyond that of the asset portfolio. Commodities and TIPS are the most effective short-term and long-term inflation hedges. Other traditionally recognized “inflation-hedging” assets offer more limited benefits. Investors have several attractive options for increasing inflation protection: Add or increase allocation to inflation-hedging assets, specifically commodities and TIPS, in the current asset allocation framework; Add a Real Return asset category, with a core of commodities and TIPS, funded proportionally from return-seeking and risk-reducing assets; Add inflation hedging assets to an "Opportunity Fund." Investors can expect to pay about 0.15% of assets in the form of reduced expected returns for a reasonable level of inflation protection, before any gains from active management. Investors with inflation-sensitive liabilities or spending should consider instituting an allocation to inflation hedging assets of 10% of the total fund.

Number of Pages in PDF File: 16

Keywords: inflation, hedging, commodities, TIPS, real return

JEL Classification: E31, N21, N22, G00, G11, G23

working papers series