A New Look across Asset Classes
May 5, 2009
Equities versus TIPS
“If you really want to hedge, use TIPS,” Roache said.
TIPS are designed to be a very effective hedge and would show up very well in Roache’s models. He did not test them because “decent data” is only available since 1997 and, until three to four years ago, liquidity was limited. TIPS were held primarily by long-term liability managers, regardless of their real yields. “Now we are starting to see TIPS as a regular asset class and ownership is broadening out, with liquidity rising,” he said.
One person who agrees that TIPS are the best hedge against inflation is Zvi Bodie, a professor of finance and economics at Boston University.
He believes everything hinges on the definition of a hedge. “If all you mean is that there is an expected risk premium associated with equities, then I agree that they can hedge risk,” he told me. “But equities are also risky. The reason to use equities is to take extra risk to earn a higher rate of return, not to hedge.”
Bodie says the investment industry and organizations such as the Investment Company Institute (a trade group representing the mutual fund industry) have marketed equities inappropriately, misleading investors about issues such as their effectiveness as inflation hedges.
“If what you want is safety, stay away from equities,” Bodie said.
Bodie’s PhD thesis was on the subject of equities as an inflation hedge, and he showed that equities were slightly negatively correlated with inflation. In a 1976 article, Common Stocks as a Hedge against Inflation, he famously argued that “this negative correlation leads to the surprising and somewhat disturbing conclusion that to use common stocks as a hedge against inflation, one must sell them short.”
“TIPS is it. Any other asset class exposes you to other types of risk,” said Bodie.
Bodie was critical of a new ETF, the WIP, which hedges against global inflation. This ETF makes sense if you believe there is default risk in US Treasury bonds, he said, but it exposes the investor to currency risk and sovereign default risk.
The WIP is an example of an “underlying fallacy in conventional wisdom that it is driving people to wrong conclusions,” Bodie said. For example, he said conventional wisdom holds that diversification reduces risk. “But it doesn’t if you are already holding the safest assets – those backed by the US Treasury,” he said. “If you take risk, you may end up earning much less.”
Implications for Retirement Portfolios
If one’s goal is to have a secure retirement – as is the case for most middle-income wage earners – and not to create an estate for your children, then Bodie says the focus should be safety.
“Retirees should be concerned with getting through the rest of their life without being dependent on their children, especially since many have to support their own parents. That burden is sometimes a big burden,” he said. “If you don’t expect an inheritance and are willing to accept the burden of caring for your parents, then the greatest thing you can do is make sure your kids don’t have that burden.”
At age 66, Bodie believes he should have no equity exposure. “All I want is security, and I buy inflation-protected bonds and life annuities,” he said, noting that a number of AA-rated insurance companies now issue inflation-protected annuities. He is still undecided about long-term-care insurance. “In some sense, I want catastrophic illness insurance beyond Medicare,” he said. “I have seen some pretty bad nursing homes.”
In short, Bodie said, “Don’t speculate with retirement wealth.”
If you are much younger, Bodie said your equity exposure depends on the risk exposure in your career. “If you are young and on a secure track toward decent and secure long-term income, then you can afford equity risk. By and large, don’t expose more than 10% to equities unless you are a high net worth individual, in which case losses don’t materially affect your standard of living.”
Bodie admits his is not the conventional view, but, he said, “that conventional view is basically false.”
Roache mostly agrees with Bodie, believing that inflation-fearing investors should rely on a direct hedging approach with TIPS or other derivatives, such as inflation swaps. He said there is “no evidence that equities offer protection in an inflationary environment.” If investors can’t do that for mandate reasons, then they should look at tactics such as commodity exposures or sector allocation strategies. “Some sectors, such as energy and mining, hedge better than others, like consumer-oriented sectors that can’t pass through inflation,” he said.
I asked Bodie for his inflation forecast. He prefaced his answer by saying that his forecast carries a very bid standard deviation and “it is not clear it matters what I predict.”
Nonetheless, he predicts inflation averaging 3% over the next decade.
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