Inflation Hedging Tools—What Works and What Doesn’t

Abstract

Inflation hit 9.1% year-over-year, spurring significant concern on the part of both institutional and retail investors. Examining the behavior of a 60/40 stock/bond portfolio over the 108.4 years ending 2/28/2023 one finds that it returned an inflation-adjusted return of 8.44% during the 75% of the months during which inflationary surprise was at its lowest. But it lost –5.18% per annum during the 25% of the months when inflationary surprise was at its highest. These data suggest that investor attention to this topic is well placed. Investors, investment managers, advisors, and strategists often discuss gold, TIPS bonds, and diversified commodities as effective, useful mitigants. But are they? This article considers 29 mitigants over the time period spanning 1914 through today and identifies those mitigants that are effective and those that are not. It presents results that strongly support the conclusion that both gold and TIPS are remarkably poor mitigants. This result is not surprising, given that gold is driven, in large measure, by its use as an event-risk mitigant, both domestic and international. Moreover, gold lacks any significant industrial use. In a similar fashion, TIPS bonds carry significant interest rate risk, which serves to disrupt their use as an inflationary surprise mitigant. The largest TIPS ETF (“TIP”) carries an effective interest rate duration of seven years. This article shows that the most effective mitigant is a 50/50 blend of broadly diversified commodities and wheat. The inclusion of wheat may be an indirect way of reducing the overall weighting to fossil fuels. Perhaps fossil fuels are playing a reduced role and agricultural foodstuffs an expanded role, as the global economy becomes less energy-intensive and the middle class grows. Finally, it is shown that the benefits of inflationary surprise mitigation rely, in large measure, on the frequency with which the mitigant is applied (not too often, but still often enough) and the dosage size. Moreover, although correct timing is highly beneficial, the benefits of mitigation still accrue to those who arrive surprisingly late to the party.