In the first, we considered the merits of assets such as government index linked bonds, equities and gold, all of which had some limitations. In this article we consider other assets that advisers could consider in meeting the outcomes that their clients seek.
Financial assets were ravaged by inflation during the 1970s episode. Institutional investors thereon began to increasingly diversify their portfolios into ‘real’ assets, such as commercial real estate. Over time lease contracts began to include automated rent uplifts in line with RPI. This presented investors with an explicit inflation hedge on the income and an implicit hedge of the capital. Today, these inflation-linked contracts have become less widespread, though a number still exist. The Aviva Property Trust is an open ended fund that has a greater representation of such contracts than its peers, so this fund would be our favoured way to gain exposure. However, it should be stressed that the majority of assets in the Trust have no explicit inflation linkage.
Another asset class worth considering during periods of rising inflation is, perhaps surprisingly, cash. Cash is not an asset renown for maintaining its real value and during periods of high inflation, the purchasing power of cash will undoubtedly diminish. However, thanks to its zero duration, it is one of the few assets that are unaffected by rising interest rates. When inflation takes off, economic uncertainty increases and real interest rates begin to climb. Valuations of assets will be marked down as discount rates increase, and assets with the longest duration will suffer the greatest losses. Cash may not protect the real value of portfolios but during inflationary periods it may do better than many other assets. Perhaps a stronger source of protection can be found in high yield short duration bonds. Such bonds have little duration and provide a yield pick up over cash. They do have distinct credit risks but many types of business find that cash flows improve during inflationary periods; this improves credit quality. Conceivably, shortish duration credit funds such as the Schroder Strategic Credit fund could do well during periods accelerating inflation.
A relatively recent development in financial markets has been the emergence of listed infrastructure assets. Although such assets have lengthy durations, the income that they generate is either implicitly or explicitly linked to inflation. Airport charges, toll roads and other utility type businesses should be relatively unaffected by a general rise in prices since consumers have little choice but to use them, regardless of cost. Many assets have charges controlled by regulators who tend to use the inflation rate as the benchmark to determine price increases. Funds such as the First State Infrastructure fund should help protect portfolios from the ravages of inflation though valuations could be vulnerable increases in real interest rates.
It is now possible to gain exposure to index-linked corporate bond funds. Compared to government index linked funds, duration risks are much lower and this should limit any losses caused by a rise in real interest rates. As these are credit funds, inflation could also conceivably bring improvements to the credit quality of the underlying holdings. The big disadvantage such strategies face, is that few companies issue index linked bonds, and those that do, are almost entirely found in the utilities sector. The M&G Index Linked Corporate Bond fund overcomes this lack of diversification by constructing bonds synthetically using derivatives. Some investors may be deterred by the complexity involved in such a strategy, though we believe that such an approach should prove its worth if inflation reignites.
Instead of constructing a portfolio using components parts, advisers may look to a single fund solution that will protect the real value of their clients wealth and grow it over time. There are a number of funds available that focus on generating performance which have explicit inflation linked targets. The Schroder Multi-Manager Diversity fund is aiming to generate returns of CPI plus 4% pa over the medium term. The portfolio is made up of a wide range of funds which the managers believe will meet their performance targets. The asset allocation is broadly split equally between bonds, equities and alternatives. A further approach that advisers might wish to consider, is the Axa Distribution fund run by Richard Marwood. The portfolio is almost entirely made up of index linked government bonds and high quality UK blue chip equities. The fund does not have an explicit index-linked target but we believe that such a portfolio should successfully maintain its real value over time.
