High and rising inflation threatens our standard of living for the first time in more than 30 years. How can we stop this invasive financial rot? What are the best inflation hedges to defend our portfolios?
The only way to separate fact from fiction is to dig into the long-term evidence. We’re looking today for asset classes that actually do hedge against inflation.
Do these investments always work? (Sneak preview: no.)Do they work for everyone regardless of where you are on your investing journey? (No again.)
Well, when do they work and for who?
Let’s find out!
Note: All investment returns quoted in this article are annualised real returns.1
How to hedge against inflation
A good inflation hedge should:
Respond quickly to high inflation, with correspondingly high nominal returns. Work reliably across many different time periods, countries, and inflation regimes.Deliver reasonable long-term returns over time.
On that last point: we’re not excited about investing in an asset class that’s a deadweight if high inflation doesn’t materialise.
The chart below from the FT summarises the inflation-hedging playing field. It draws on data from a 2021 research paper: The Best Strategies For Inflationary Times:
Look at energy commodities go! Do we already have a winner? The best hedge against inflation?
The trend-following strategy also looks excellent. Gold shines, too. And few of us would mind stocking up on wine. This seems easy.
Sadly it’s not.
Inflated expectations
Reading the 2021 paper in detail reveals inflation-hedging to be (yet) another investing minefield.
None of the inflation hedge ‘winners’ in the chart above prove to be no-brainers:
Each asset class comes with more baggage than RyanairFew work consistentlySome have poor long-term returns
Alas, there is no magic bullet answer to the question: “what is the best hedge against inflation?”
Taken together, the top inflation hedges resemble a ragtag crew of mercenary misfits. Sometimes they’ll come through for you: unleashing a spectacular display of inflation-busting pyrotechnics. Other times, they’ll fall on their face like a drunk, trousers round their ankles. An embarrassing mistake.
These complications mean we believe deliberate inflation-hedging makes less sense for early- to mid-stage accumulators than for near-retirees and decumulators.
When you’ve decades to go, concentrate on beating inflation over the long-term. That makes more sense than hedging against a short-term risk.
As for near-retirees and decumulators, let’s consider which of the reputed inflation hedges you may want on your side.
Inflation hedge: commodities
Energy commodities delivered an average 41% return across the eight high inflation episodes that haunted the US from 1926 to 2020. That’s according to The Best Strategies For Inflationary Times paper.
Sounds great – bar three devilish details:
Returns were negative during three of the episodes. Returns averaged -1% outside of the inflationary periods. The average return was 3% across the entire timeline.Six out of eight episodes were calculated using spot prices. But private investors can only invest in commodity future funds.2
The fact that energy commodities didn’t hedge against inflation every time doesn’t bother me. Hardly any asset class does.
My concern is that while many papers make the inflation-hedging case for energy commodities, I’ve yet to find one that tests the hypothesis using actually investible assets.
Researchers work with spot prices or commodity future indexes. But indexes don’t include costs. Also, commodity index-tracking funds such as ETCs are vulnerable to exploitation by major-league investment firms.
Financial players with superior information can trade against the ponderous and predictable ETCs.
Known as ‘front-running’, this strategy enables active investors to profit at the expense of passive commodity vehicles.
The commodity rollercoaster
To add to the gloom, long-term studies of broad commodities suggest you can expect to get bond-like returns allied to equity-like volatility.
That’s the worst of both worlds. Like two drunks in a storm.
Just look at the 10-year returns of Energy ETCs available to UK investors:
Source: Trustnet Multi-Charting tool
These energy ETCs all had a great past year – on cue – as unexpected inflation concerns emerged in 2021.
But could you take annualised losses of 4% plus for ten years straight? (Trustnet’s returns are nominal, so you have to add inflation to those losses, too.)
It gets worse. Go to WisdomTree’s website and check some of its ETC’s records since 2007. The losses make them look like Monty Python’s Black Knight. Amputated arms and legs strewn about, while a stumpy torso squirts blood.
Diversifying across all commodity sectors sometimes outperforms energy in different inflation regimes. But my wider concerns remain.
Iffy investment vehicles and a poor expected risk-reward profile begs the question: are commodity inflation-hedges worth it when you could go for simple inflation-beating equities instead?
I believe commodities rack up unnecessary risk for ordinary investors.
Inflation hedge: gold
Gold has gained a reputation as a hedge against inflation. Supposedly it can buy about the same amount of bread in the modern era as it could in 562 BC.
I’m not sure how many sourdough baps my local baker offers for an ounce of gold. But the next graph does not show a strong correlation between UK inflation and the yellow metal:
Source: Elroy Dimson, Paul Marsh, and Mike Staunton.
Credit Suisse Global Investment Returns Yearbook 2012. Page 12.
The purchasing power of gold is indicated by the dark blue line. It should be flat if gold is a sound short-term inflation hedge. Instead it’s all over the show.
That’s true for the gold standard era and also for the fiat money era post-1971.
The next graph shows gold’s performance during different inflation regimes across multiple developed countries:
Source: Elroy Dimson, Paul Marsh, and Mike Staunton.
Credit Suisse Global Investment Returns Yearbook 2012. Page 12.
Now we’re getting somewhere! Gold outperforms cash when the inflation rate is above 8%. It also beats the equity and bond returns we saw in our inflation and the stock market post.
True, when inflation hits 18% or more, gold’s return is slightly negative. But that’s preferable to the -21% average returns of cash. (Not to mention equities -10% or bonds -25%, as per our previous article).
Golden years
Gold turned in average returns of 13% during the four inflationary regimes post-1971, according to The Best Strategies For Inflationary Times.
But the paper’s authors then break our hopeful hearts by warning:
Looking at averages over all regimes could be misleading because of one influential regime. For example, Erb and Harvey (2013) show that gold’s seeming ability to hedge unexpected inflation is driven by a single observation.
And here is that single observation. The gold price shot up near 200% in 1980:
Source: Claude Erb and Campbell Harvey. The Golden Dilemma. 2013. Page 9.
Even Erb and Harvey say of gold’s relationship with unexpected inflation:
There is effectively no correlation here. Any observed positive relationship is driven by a single year, 1980.
Meanwhile, the academics Dimson, Marsh, and Staunton put gold’s long-term average return at around the 1% mark. That’s about the same as cash, but with much higher volatility.
That return disguises a 40-year slump from 1980 to 2001. Gold lost 75% of its value in pounds and 80% in dollar terms.
Not all that glitters
Somehow I always end up in the same ambivalent place with gold. The charts show it soaring like a NYC pencil-tower in the ‘70s and during the Great Recession.
You’d always want gold in your portfolio if you could rely on it doing that.
But that 40-year horror show where the price went down and down is a cautionary tale.
Accumulators can happily skip the quandary. Decumulators who want to ward off sequence of returns risk may want to use gold sparingly as disaster insurance.
But the case for it as an inflation hedge is weak.
Inflation hedge: real estate
Dimson, Marsh, and Staunton found that commercial real estate returns are negatively impacted by high inflation, though less so than broad equities.
However, that could be an artefact of sluggish property prices. In other words, the inflation effect is simply delayed in comparison to liquid equity markets.
Because REITs have reasonable long-term returns but a negative relationship with inflation, commercial property is best thought of as an inflation-beating strategy. As opposed to an inflation hedge.
The trio tentatively suggest that residential property is quite resistant to inflation. But returns still have a negative relationship with high prices.
However the verdict in The Best Strategies For Inflationary Times is a little more encouraging.
UK residential property delivered a 1% average return during high inflation periods. Returns were positive in 57% of the 14 periods examined between 1926 and 2020.
Incredibly, Japanese residential property delivered 12% average returns with a 100% positive return across six high inflation episodes from 1926 to 2020.
But US residential property returns were -2% during inflationary bouts. It only mounted a positive response a quarter of the time.
Location, location, location
Keep in mind that unique factors could be at play in each of these markets.
We also can’t ignore the fact that historical records of property prices are notoriously problematic.
Long-term data typically fails to capture high-resolution details such as ownership costs, rental assumptions, taxes, default risks, transaction costs, and illiquidity.
You have to put a peg on your nose every time you lend credence to historical property returns.
UK homeowners conditioned by a 30-year property bull market have long thought of their castles as a bastion against inflation.
And residential property did deliver a positive return in two out of three episodes during the ‘70s, according to The Best Strategies For Inflationary Times.
But that’s little comfort for anyone struggling to get on the housing ladder.
Moreover, it’s difficult to diversify residential risks. Even a portfolio of rental properties is prey to local market conditions. These can swamp any inflation effect.
Inflation hedge: stocks and equity sectors
Can individual stocks or sectors serve up inflation hedging salvation where the broad equity market cannot?
Dimson, Marsh, and Staunton sound dubious:
It is tough to find individual equities, or classes of equities, or sectors that are reliable as hedges against inflation, whether the focus is on utilities, infrastructure, REITs, stocks with low inflation betas, or other attributes.
Meanwhile, Neville et al investigate the performance of 12 US stock sectors. Every sector except energy stocks posted negative returns during high inflation periods.
The energy sector did manage a 1% average return during those periods. But the return was only positive 50% of the time.
Notably, average returns were -19% during the 1972-74 recession that was infamously fuelled by the OPEC oil embargo.
Ultimately, equity prices are subject to a swirl of forces beyond inflation. These can confound a simple thesis, such as high oil prices must be good for oil firms.
Looking for the X factor
Three other equity sub-asset classes posted positive returns during high inflation regimes. These are three of the risk factors:
Momentum looks especially hopeful with 8% average returns, and positive returns in three-quarters of the scenarios considered in The Best Strategies For Inflationary Times.
The snag is these compelling results tested the long-short version of cross-sectional momentum.
But us ordinary UK investors can only access long-only momentum ETFs. They offer a diluted version of the pure form examined in the paper.
Once again our hopes are stymied by the gap between back-tested theory and investible reality.
The authors also say they’re cautious about momentum’s results, due to its low statistical significance and its sensitivity to their chosen dates:
For example, January 1975 was a very negative month for cross-sectional momentum, and our inflationary regime stops in December 1974. Equally, late 2008 through early 2009 was catastrophic for momentum, and our inflationary period ends in July 2008.
However, the authors do make encouraging observations about the benefit of straightforward international equity diversification:
Equities really only struggle when two or more countries are suffering. This is consistent with a global bout of inflation being very negative for equity markets.
The results also suggest benefits to international diversification. For example, taking the UK perspective, US and Japanese equities generate +6% and +9% real annualized returns during UK inflation regimes, respectively. This is perhaps one of the drivers behind the large international equity allocations run by some of the major UK pension funds coming out of the inflationary 1970s and 80s.
Inflation hedge: crypto
There’s no evidence one way or the other that crypto protects against inflation.
Any other conclusion is speculative given we’re experiencing our first dose of unexpected inflation since the dawn of these assets.
You can check the price returns of various crypto assets right now. They’re characterised by extreme volatility, not stickiness to monthly inflation.
Neville and chums considered Bitcoin in their study. In their opinion, the limited evidence points against so-called digital gold being an effective inflation hedge:
…bitcoin is a speculative asset and it has a positive beta against the U.S. market. Our analysis shows that unexpected high inflation is negatively related to U.S. equity returns. The correlation of U.S. equity and bitcoin returns suggests that bitcoin may not deliver positive real returns in periods of unexpected inflation.
We won’t really know for years.
Crypto – like any exciting, emergent cultural space – is virgin territory upon which people are projecting their hopes and dreams.
This is not a phenomenon from which we can draw reliable conclusions.
Inflation hedge: index-linked gilts
Index-linked bonds hedge against inflation by pumping up your coupon3 and principal payments so that they match an appropriate official rate.
That rate is RPI for the UK government’s index-linked gilts.
If you buy individual index-linked gilts and hold them to maturity then they will act as an inflation hedge.
This is the best inflation hedge you can get in the sense that it will reliably protect your purchasing power against official inflation.
But – of course – I can’t just leave it at that and let us all sleep soundly in our beds.
What a downer
The main problem is that index-linked gilts are very expensive. Demand is so high that they are on negative yields to maturity (YTM).
For example, a 10-year index linked gilt currently yields -2.8%. Inescapable bond maths means you’ll take a loss of -2.8% per year if you buy and hold it to maturity.
So why would you ever do that?
Well, because if you invest, say, £10,000 then you may decide that £280 a year is a price worth paying to ensure your money isn’t consumed by runaway inflation.
Essentially, the -2.8% yield is an insurance premium you pay to protect your money against inflation.
It’s an expensive business, but by buying and holding individual index-linked gilts, you could ensure regular inflation-hedged payouts from now until 2050.
Building a bond ladder like this is a complicated area that needs another post to cover.
Until then, Barcap published a PDF a while ago with more details on investing in individual index-linked gilts (and much more).
Duration and interest rate risk
Normally we’d recommend funds or ETFs as a one-stop shop for passive investors.
But interest rate risk is a big problem with index-linked bond funds and ETFs right now. That’s because managers constantly sell their holdings to maintain the fund’s duration.
Depending on how the interest rate market goes, you could find your linker fund registering a capital loss when you sell. You’d thus fall short of the liabilities you hoped your index-linked gilts would cover.
As an accumulator you needn’t be a forced seller. But the game changes in decumulation.
The usual advice is to match your bond fund’s duration to your future liabilities to avoid shortfalls. Then gradually move to shorter duration funds as your liabilities close in like zombies.
But that’s next to impossible with publicly available index-linked gilt funds because they have very long durations.
Such funds expose you to the possibility that capital losses inflicted by rising real yields will overwhelm the inflation protection you first sought.
Short-term global index-linked bond funds hedged to GBP do exist. They’re more palatable, but they still embed some real yield risk.
Ineffective bonds
Dimson, Staunton and Marsh sum up index-linked bonds nicely when they say:
As a safe haven for investors concerned with the purchasing power of their portfolio, index-linked bonds offer a highly effective means of reducing real risk.
In today’s market, however, they can make little contribution to achieving a positive real return over the period from investment to maturity.
Accumulators are probably better advised putting their faith in an inflation-beating strategy than paying the inflation insurance embedded in index-linked bond prices.
Two final points:
Index-linked gilts will be linked to CPIH not RPI from 2030. CPIH typically estimates inflation to be 0.5% to 1% lower than RPI.4
Official rates like RPI and CPIH may not match your personal inflation rate. That’s another reason to consider prioritising an inflation-beating strategy above hedges.
Inflation-hedge: timberland
Timberland enthusiasts describe it as the dream package. Who wouldn’t want an inflation hedge that offers good risk-adjusted returns, plus low correlations with equities and bonds?
But even fund managers selling timber investments confess the asset class has been a moderate inflation hedge at best.
Alternative investment firm Domain Capital states:
Timber has been found to be positively correlated with unanticipated inflation. During periods of high inflation, as in the 1970s, timber provided a partial inflation hedge. With a correlation of 0.34 to inflation during the 1970s, timber prices tended to outpace unexpectedly high inflation.
Timely correlation recap:
1 = Perfect positive correlation: when one thing goes up so does the other0 = Zero correlation: the two things being measured have no influence upon each other -1 = Perfect negative correlation: when one thing goes up, the other goes down
A correlation of 0.34 during the stagflationary 1970s is not great.
The timberland / inflation correlation then drops to 0.29 between 2003 to 2017.
Between 1987 and 2010, the correlation was 0.64 according to Barclays Global Inflation-Linked Products – A User’s Guide.
That compares with inflation correlations of 0.80 to commodities and 0.84 to short-term index-linked gilts.
The bigger problem I encountered when trying to stand up timberland is that sources tend to use data from the NCREIF Timberland Index.
This US index has two main issues:
It only tracks timberland’s performance from 1987. That’s a pretty short timescale. Especially given that inflation has been quite benign since the late 80s.
The index is dominated by private equity companies that invest in timber and forestry. Those companies are inaccessible to retail investors like us.
Instead, we can invest in publicly-traded timber REITs and forest product companies.
Barking up the wrong tree
The S&P Global Timber & Forestry Index is the most popular index covering public timberland firms.
You can gain exposure to it using an iShares ETF: ticker WOOD. (Do you see what they did there?)
But we’re stumped again! Public timber stocks are much less effective inflation hedges than their private equity brethren, according to the paper Assessing the Inflation Hedging Ability of Timberland Assets in the United States.
Its authors concluded:
Private-equity timberland assets can hedge both expected and unexpected inflation, and the ability becomes stronger as the investment time increases.
In contrast, public-equity timberland asset is not effective in hedging either.
As for timberland’s diversification benefits, they say:
In summary, private-equity timberland assets have a negative correlation with the market and are a good hedge against actual inflation. On the other hand, public-equity timberland assets behave more like common stocks and have a high correlation with the market.
The study covers the period 1987 through 2009. But it chimes with my anecdotal experience of keeping an eye on iShares’ WOOD.
WOOD’s returns have been closely correlated to MSCI World ETFs. Ultimately, I’ve not been able to justify branching out into timber. [Ed – fired!]
Trendy hedging
You’ll remember that the trend-following strategy looked great in the FT’s Inflation winners and losers chart we saw many leagues above.
Trend-following scored average returns of 25% in inflationary periods according to The Best Strategies For Inflationary Times. It also worked reliably in all eight scenarios.
Returns for the entire 1926 to 2020 period were an astounding 16%.
At this point, I wish I knew how to execute a proprietary trend-following strategy using futures and forwards contracts associated with commodities, currency, bond, and equity prices.
Because that’s what the authors backtested.
They name check their methodology. But I’d guess this strategy is beyond the ken of most people.
Other inflation hedges
Our final inflation hedging candidates are collectibles: wine, art and stamps. The Best Strategies For Inflationary Times suggests they have game:
Collectible
Inflation episode average return (%)
Anti-inflation reliability (%)
Wine
5
50
Art
7
63
Stamps
9
75
But once again the academics are building a case on an index you can’t invest in. The underlying data ignores transaction fees, storage, and insurance costs. All of which would chomp down those returns.
But more importantly, the average punter is going to struggle to put together a diverse basket of Old Masters.
Right now there’s no ETF tracking the market for Picassos, Warhols, and Cézannes.
If you can profitably swim in those waters then best of luck to you. Hopefully you’re not just sticking this treasure in a vault for the purpose of inflation hedging.
The Investor covered some of the pitfalls of investing in illiquid and opaque markets in this piece on alternative asset classes.
Beating inflation
So where does that leave us, except more disillusioned than ever?
As previously stated, because inflation hedging is so problematic I’d skip it if I was still an accumulator. I’d rely on straightforward global equities to beat inflation instead.
But decumulators and retirees are highly vulnerable to unexpected inflation.
The most reliable buy-and-hold method to hedge inflation is to create a ladder of individual index-linked gilts. (More on that in a future post, or see that Barcap report).
The less reliable method is a short-term global inflation-linked bond fund or ETF hedged to GBP.5
Other hedges embed drawbacks that can go into buckets marked ‘investibility’ and ‘reliability’.
Those spectres may well be enough to chase you off like visitors to a haunted theme park.
But it’s only fair to say that asset classes like gold and commodities have had their moments.
Hedging your hedging bets
You may consider inflation to be such a threat that it justifies a small percentage to each of the assets we’ve covered. This way you have a diversified hedge against inflation.
Is it worth it? Only you can decide what’s right for you.
I’ll give the last word to Dimson, Staunton, and Marsh. Their peerless work acts as a shining light for us ordinary investors in search of answers:
Inflation protection has a cost in terms of lower expected returns. While an inflation-protected portfolio may perform better when there is a shock to the general price level, during periods of disinflation or deflation such a portfolio can be expected to under-perform.
Take it steady,
The Accumulator
Annualised is the average annual return accounting for gains and losses. Real return is the amount the investment grows (or shrinks) over a period after inflation is stripped out.Commodity futures data isn’t available before 1987.Bond interest payout.In a characteristic sleight of hand by the government, it looks like index-linked gilts will still link to RPI from 2030. But RPI will be officially calculated using CPIH from the switchover date. Hence linkers will align to CPIH in reality.Hedging to GBP neutralises currency risk. A good thing for retirees.
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