What To Think About If You Are Worried About Inflation

While a lot of investment commentators talk breathlessly about different types of assets being “inflation hedges” the reality, as usual, is more complicated.

Specifically, there are five key points investors should consider as they position their portfolios in response to today’s inflation picture.

First, there are different types of inflation-hedging abilities offered by various assets. Some assets can offer a fairly direct performance relative to inflation and others only offer a roundabout or uncertain performance relative to inflation. Knowing the difference will help investors avoid disappointment and allow them to take more inflation risk in the rest of their portfolios.

It’s important to say outright that it’s actually very hard for retail investors to find assets to truly “hedge inflation.” When investment professionals talk about instruments to “hedge X” they mean financial instruments whose main performance is linked to X. So, for example, a hedge of the broader US equity market could be something like a put or a short futures position on the S&P 500 index. These instruments are true hedges for the S&P 500.

The reason this is important is that there are no true inflation hedges available to retail investors. For instance, while institutional investors have access to inflation swaps whose payoff is linked directly to the CPI index and nothing else, retail investors have to do with a smaller subset of securities.

The second key point is that all the different assets available to income investors with a beta to inflation also tend to come with other kinds of embedded risks. These could be general macro risks such as the level of economic activity (particularly relevant for various equity sectors such as REITs), credit risk (such as loans) or duration risk (in the case of TIPS (Treasury Inflation-Protected Security), for example). This means that investors who pick a specific asset for its supposed inflation-linked performance also have to be comfortable with all the other risk factors that come along for the ride.

The third key point is that hedges don’t come for free. Investors often talk about hedges as no-brainers. For example, why would you own stocks outright when you can own a collared equity fund which provides exposure to the same set of stocks but with better downside protection due to the sold call premiums as well as the downside puts (a collar is a strategy that buys downside puts and sells upside calls). An understanding of the cost of downside puts / the give-up of the upside from the calls or even a quick glance at the longer-term performance of collared or covered call strategies relative to their equity benchmarks will show very clearly that using hedges indiscriminately will result in an asset that is not going to have very attractive returns over the longer term. Ultimately, investors are compensated for taking risk – a riskless asset is one which should perform in line with short-term risk-free rates like Treasury Bills. This suggests that often investors are better off simply avoiding a particular risk rather than hedging it.

The fourth key point is making the distinction between taking/not taking a certain risk and whether that risk is well compensated/not well compensated. For example, it may seem ludicrous to put yourself “in the eye of the storm” and take credit or equity risk during a period like the COVID drawdown. However, market history shows that it is often when assets are beat up that they offer exceptional opportunities by virtue of rewarding investors for taking risk. And it is often when assets are “priced for perfection” that their risk is not worth taking. The same is true with inflation – when inflation risk is well compensated it can make sense to take and when it is not, investors may want to avoid it.

The fifth point is that investors need to make a distinction between rising inflation and high inflation. Investors who want to hedge rising inflation want to mitigate the damage in their portfolio of, say, CPI rising from the current 8.5% year-on-year rate to something like 10-12% which can be a sensible move for investors very worried about this eventuality. However, investors who simply worry that inflation may remain high over the next year or so at, say 6-9%, don’t actually have great options. This is because the consensus is for inflation to remain elevated (though falling over time). The current level of inflation is largely in the price of the overall market and the damage to assets highly sensitive to inflation has already been done, leaving very little, if anything, to hedge. Hedging is more useful when it pertains to a non-consensus potential future development because it is these developments that can be most damaging to asset prices.

Thanks for reading.

Check out more in-depth and timely commentary as well as Income Portfolios and interactive Investor Tools at our Premium service.


ADS Analytics LLC / Systematic Income provides opinions regarding securities and other related topics on an impersonal basis; therefore no consideration is made towards your individual financial circumstances.

All content presented here is not to be regarded as investment advice or constitute a client / advisor relationship. It is for general informational purpose only.

Trading securities involves risk, so you must always use your own best judgment when trading securities. You assume the entire cost and risk of any trading you choose to undertake. You are completely responsible for making any investment decisions.

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.