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Jeffrey Notaro
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I am both an investment advisor and a fund manager with a specialization in alternative assets. My advisory business focuses on helping families and individuals grow their portfolios, hedge inflation costs and prepare for retirement. My fund management businesses targets farmland and real estate... More
My company:
Black Sea Agriculture
My blog:
Black Sea Agriculture Insights
  • How To Construct A Portfolio Hedged For Inflation 0 comments
    Sep 25, 2013 9:09 PM

    Deciding how to allocate assets in today's economic environment in a way that deals with the very rational fear of high inflation and/or the possibility of a steep drop in equity prices is a real dilemma faced by individual investors and investment advisors alike. As a solution, I will propose in this article an allocation with the following features: (1) limiting the amount of equities to a manageable proportion, (2) allocating a significant amount to bonds and income assets, and (3) including a hedge using farmland and gold. There are issues and sacrifices with this plan, but the goal is to preserve wealth in times of financial turmoil and still be in a position to earn a respectable overall return.

    Before looking at the portfolio allocations, let's define the assets themselves.

    Bonds: Interest rates are obviously extremely low so there is no logic in considering long-dated bonds. To pick-up an any reasonable yield you have to consider the low end of investment grade rated bonds (BBB and A) and some sub-investment grade issues (BB and B). I suggest by carefully choosing the issuers, diversifying as much as possible and sticking to 3 to 5 year maturities, the risks from defaults will be very limited. By planning on holding all of the bonds until they mature eliminates the risk associated with higher interest rates.

    Income: Including a modest amount of non-bank preferred stocks and floating-rate bank loans adds some healthy cash-flow. By planning to hold these income assets for the very long term means the annual price changes are not as important to the portfolio's performance. This might seem a bit odd, but if the fundamentals of the companies are sound (relatively speaking) and the holdings are well diversified, it will should be easier to sit with the any swings in price and just focus on banking the relatively high cash-flow each year.

    Equities: A mix of various slices of the U.S. and international markets makes sense for the long-term investor, but for this analysis I will use the S&P 500 including dividends to keep it simple.

    Farmland: This is the most significant allocation that is expected to offset the scourges of inflation and potentially compensate for any big losing years for the stock market. For analysis purposes in this article, I use historical data of the average farmland price for the northern Mid-West states plus a very modest 3% a year leasing income. I realize farmland is not easy to include in a portfolio; plus at this time most developed agriculture regions looking to be at best fairly priced at current levels if not overpriced. The answer is to focus on emerging markets. These areas have increased in value too responding to increased world food demand and higher farm profits; but some are still cheap because they are in the midst of modernizing. I can personally testify that my area of expertise in the Black Sea region of Eastern Europe still offers a lot of value based on future increased production potential, but the same should be true for parts of South America and Africa. To invest in farmland anywhere, the most practical method is to utilize professional farm management services or invest in private limited partnership style funds. Obviously investing in farmland is not as easy as buying an ETF but protecting your portfolio from the inflation and picking up a growth asset that is not correlated to stocks is worth the effort.

    Gold: The latest massive swoon in gold prices highlights why it does not make sense to include a big allocation of gold. The lack of any dividend or definable "fair value" only acts to reinforce this argument. But gold has sometimes gone up exponentially during times of inflation thereby justifying including a limited amount of this a volatile hedge.

    In further posts, I will explain some of these asset classes in more detail and my suggestions exactly how to invest in them, but the focus for this article will be on the overall asset allocation (which most research shows to be the most important anyway) and how proper choices could potentially avoid the loss of buying power from inflation and/or compensate for drops in the stock market.

    This following portfolio analysis is unconventional because it combines the average historical total returns for farmland, gold and equities and only the current yields from the bonds and the income holdings, ignoring the bond and income asset price changes. Remember the plan is to buy (now) and hold short-dated bonds to maturity and keep the income assets long-term; therefore their price changes are ignored. For all the other assets we do care very much about price change and will use historical data to shed some light on what to expect (as imperfect as that is).

    The data for the analysis covers the years from 1971 through 2012. The choice of the starting point coincides with the free floating of gold prices in the U.S. Inflation is measured by the CPI. The first table shows the performance of each growth and hedge oriented asset classes during the worst years for inflation since 1971 as defined by the CPI over 6%.

    Worst inflation years

         
     

    Farmland

    Gold

    Stocks

    CPI

    1980

    10%

    99%

    17%

    14%

    1979

    17%

    59%

    16%

    11%

    1974

    26%

    63%

    -15%

    11%

    1981

    4%

    -25%

    25%

    10%

    1975

    25%

    1%

    -19%

    9%

    1978

    20%

    31%

    -7%

    8%

    1977

    16%

    18%

    12%

    6%

    1973

    27%

    67%

    17%

    6%

    1982

    -13%

    -18%

    -6%

    6%

    1976

    31%

    -22%

    38%

    6%

    Average

    16%

    27%

    8%

    9%

    Here is how the portfolio looks with the back-tested average returns for the growth and hedge assets and the current cash-flow only for the bonds and income assets.

     

    Portfolio Allocation

    Annual Return

    Portfolio Net Effect

    Corporate Bonds

    20%

    2.3%

    0.47%

    Corporate High Yield Bonds

    10%

    3.5%

    0.35%

    Preferred Stocks

    5%

    6.3%

    0.31%

    Floating Rate Bank Loans

    5%

    4.7%

    0.23%

    Equities

    30%

    7.7%

    2.30%

    Farmland

    25%

    16.3%

    4.08%

    Gold

    5%

    27.3%

    1.36%

    Total Return

    100%

     

    9.1%

    Inflation measured by the CPI

      

    8.7%

    It looks like there is nothing to worry about - mainly because stocks actually show an average positive return during the some of the high inflationary years. There is some truth that stocks sometimes do well during inflationary years. But not all the years and with all the volatility, the entry point becomes a big factor (getting in just before a big down year would create a poor starting point, which could easily happen now.)

    So let's see how this same mix of assets performs during only the down years for the stock market during high inflation years.

    Worst stock years during the worst inflation years

         
     

    Farmland

    Gold

    Stocks

    CPI

    1975

    25%

    1%

    -19%

    9%

    1974

    26%

    63%

    -15%

    11%

    1978

    20%

    31%

    -7%

    8%

    1982

    -13%

    -18%

    -6%

    6%

    Average

    15%

    19%

    -12%

    8%

     

    Portfolio Allocation

    Annual Return

    Portfolio Net Effect

    Corporate Bonds

    20%

    2.3%

    0.47%

    Corporate High Yield Bonds

    10%

    3.5%

    0.35%

    Preferred Stocks

    5%

    6.3%

    0.31%

    Floating Rate Bank Loans

    5%

    4.7%

    0.23%

    Equities

    30%

    -12.0%

    -3.59%

    Farmland

    25%

    14.5%

    3.63%

    Gold

    5%

    19.2%

    0.96%

    Total Return

      

    2.3%

    Inflation measured by the CPI

      

    8.5%

    Inflation is not entirely compensated for, but the portfolio shows a decent positive return during some bad years and most importantly does not sustain a big loss.

    The sample size is rather small in this example, so let's now look at all the down years since 1971 for the stock market as defined by a drop of more than 1% compared with the returns those years for farmland and gold plus the same current yield for our bonds and income assets.

    All down years for stocks since 1971

     
         
     

    Farmland

    Gold

    Stocks

    CPI

    2009

    6%

    12%

    -35%

    0%

    2003

    11%

    17%

    -19%

    2%

    1975

    25%

    1%

    -19%

    9%

    1974

    26%

    63%

    -15%

    11%

    2002

    12%

    14%

    -13%

    2%

    1978

    20%

    31%

    -7%

    8%

    1982

    -13%

    -18%

    -6%

    6%

    2001

    9%

    -3%

    -5%

    3%

    Average

    12%

    15%

    -15%

    5%

     

    Portfolio Allocation

    Annual Return

    Portfolio Net Effect

    Corporate Bonds

    20%

    2.3%

    0.47%

    Corporate High Yield Bonds

    10%

    3.5%

    0.35%

    Preferred Stocks

    5%

    6.3%

    0.31%

    Floating Rate Bank Loans

    5%

    4.7%

    0.23%

    Equities

    30%

    -15.0%

    -4.51%

    Farmland

    25%

    12.0%

    3.00%

    Gold

    5%

    14.6%

    0.73%

    Total Return

    100%

     

    0.6%

    Inflation measured by the CPI

      

    5.0%

    Again, the result is a positive return that keeps the portfolio intact for the future.

    If the allocation for farmland and gold are increased to 35% and 10% respectively and bonds and stocks reduced, the return nearly matches inflation.

    Worst inflation years that had lower stock prices with more farmland and gold

     
         
     

    Portfolio Allocation

    Annual Return

    Portfolio Net Effect

     

    Corporate Bonds

    15%

    2.3%

    0.35%

     

    Corporate High Yield Bonds

    5%

    3.5%

    0.17%

     

    Preferred Stocks

    5%

    6.3%

    0.31%

     

    Floating Rate Bank Loans

    5%

    4.7%

    0.23%

     

    Equities

    25%

    -12.0%

    -2.99%

     

    Farmland

    35%

    14.5%

    5.08%

     

    Gold

    10%

    19.2%

    1.92%

     

    Total Return

      

    5.1%

     

    Inflation measured by the CPI

      

    8.5%

     
          

    This all may seem simplistic and the historical data base too narrow. Consider though that most traditional allocations would assume a sizeable share of long-term bonds. With interest rates so low there is no logic to holding a meaningful amount of long-dated bonds. The idea of holding short-term bonds with little yield might seem like a waste of resources, but it is a low risk way to keep a portion of the capital working with it automatically becoming available reinvestment as the bonds mature. Ignoring price changes in preferred stocks and floating rate loans might be naive, especially if one looks at where these items traded in 2008; but by keeping the allocations small and avoiding the eternally risky banking industry, this should not be an issue for worry. So in the end, the stability and inflation hedging is achieved by allocating a significant amount to short-term bonds and income, limiting the amount of stocks, keeping a small amount of gold around and making the effort to include a good farmland investment.

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