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What caught my eye this week.
One of the most dismaying aspects of the past decade’s political shift is seeing people who’ve thrived under ‘the system’ now shaking their fists at it.
From Donald Trump railing against corporations after presiding over several occasionally bankrupt ones, to the Chinese state turning on its most successful tech firms, to Barry Blimp and his friends criticising the elites from their exclusive spa and pool complex in Berkshire, hostility towards free market economics is everywhere. We see the consequences in rising US protectionism and the diminishment of Great Britain PLC and her citizens thanks to that vote.
It’s one thing to bemoan globalisation if you’re an artisanal farmer in Africa displaced by cheap calories from China, or a former industrial worker with now-redundant skills in Scunthorpe or Flint.
But well-to-do Brits decrying the shadowy forces of international trade that paid for their pensions? With zero evidence except a few half-baked statistics from fringe economists talking out of their Agas?
I’d take Citizen Smith over them any day.
Down with prosperity!
Combine the increasing antipathy towards global trade on the right with the age-old hostility towards enterprise on the left, whiz it in a social media blender, and you get this:
We could quibble over Zitelmann’s definitions I’m sure. But you only need to spend 20 minutes on Twitter or to listen to certain popular populist politicians to know the anti-capitalism vibe is real.
Yet as Joachim Klement argued when he shared Zitelmann’s graph this week:
Capitalism is responsible for creating more wealth and progress than any other economic system ever invented. It has lifted more people out of poverty than all charitable efforts and aid organisations put together. It has taken us out of the Malthusian trap and increased agricultural productivity to a level where we can feed more than eight billion people on the planet, most of whom would have died of starvation or never been born without the financial means to develop modern agriculture. And it has provided the foundations on which health standards have increased so much that global life expectancy has more than doubled in the last 100 years.
Few would say everything is perfect. Certainly not me. Just look at the other graph in this week’s Weekend Reading below.
But most of our problems stem from political choices and voter selfishness, wishful thinking, or even outright incredulity, rather than unfixable issues with capitalism.
Capitalism provides a framework for incentives to work. But it’s up to governments and voters to decide the rules of the game, what to reward, and how to divvy up the proceeds.
Capitalism isn’t dead. But it needs to fix itself. More of us should learn how to be capitalists, and to understand the source of our wider prosperity.
Quant fund pioneer Jim Simons, who died this past week, once said: “I did a lot of math. I made a lot of money, and I gave almost all of it away.”
Not a bad template for the ideal capitalist. But many people might start with simply doing the maths.
Have a great weekend!
Over on Monevator Moguls, we’ve been kicking the tyres on several investment trusts during the past year.
There was a big dislocation in the closed-end fund market when interest rates soared in 2022. Even the beloved ‘dividend heroes’ went cheap in the sales.
Elsewhere, infrastructure trusts that had previously traded on giddy 20% premiums to net assets (NAVs) fell to that level of discount. This 20% premium to 20% discount swing was independent of any move in their underlying assets. Some even reported rising NAVs!
Meanwhile you could drive a truck through the discounts on private equity and venture capital trusts. The most heavily-discounted traded at 40p on the (purported) £1 or less.
All told the average trust discount reached 19% last year – a level not seen since the financial crisis.
Even after a mini-rally, the average discount is still in double-digits.
Cheap for a reason(s)
So, fill your boots, active investors?
Well perhaps – with all due caveats. And assuming you’re a naughty type who understands the risks and hassles as well as any potential rewards.
But should you decide to wade into this Sturm und Drang intent on bagging a bargain, your favourite investing platform/broker may have other ideas.
The reason why harkens back to why some investment trusts may have sold off quite so severely.
99 problems and a glitch ain’t one
The woes of the investment trust sector is multi-factored if not omni-shambled.
The bear market of 2022 blew the trumpet on the start of the carnage as interest rates rose. The unloved UK market tossing everything into the bargain bin didn’t help either.
Investment trust discounts and premiums being buffeted around by supply, demand, and the emotional state of the market is nothing new.
But in this particular sell-off, trusts have also faced local turbulence that’s sent some into a tailspin.
For a start there’s the Consumer Duty regulations of 2023 that might make advisors more wary of exposing their clients to the extra complexities of investment trusts – and themselves to legal liability.
Wealth manager consolidation may also have forced the selling of certain trusts. It’s also left some trusts too small for the now-bigger managers to bother with.
Finally new-ish cost disclosure rules – derived from two pieces of legislation we retained after leaving the EU1 – seem to have been implemented in a particular obtuse way in the UK.
According to the investment trust industry, this has put trusts at an unfair disadvantage versus other kinds of funds.
How much?
On the latter point, even the House of Lords has criticised the way the Financial Conduct Authority (FCA) has implemented the cost disclosure requirements.
The Financial Times neatly summarises the situation:
The way the FCA interprets these pieces of legislation compels investment trusts to report their costs in the same format as open-ended funds.
The result is that investment trusts look more expensive than they actually are.
[For instance, in the accounts of the Temple Bar investment Trust] the ongoing charge – an expression of the company’s management fees and operating expenses – is 0.56%.
But if you look at the Key Information Document, devised by regulators to help investors make more informed investment decisions, the annual ‘cost impact on return’ is 1.48%; and if you exit after five years you’ll pay £712 in total on an example investment of £10,000 […]
These metrics are fine for open-ended fund fees, which deduct management fees when the daily unit price is updated.
But for investment trusts, fees and costs simply reduce the net asset value that an investor has a stake in by owning shares. Investors will also pay broker trading and stamp duty fees to own those shares.
The investment trust industry says the onerous cost disclosure regime has put off both retail and professional advisors, which has further weakened demand and driven discounts even wider.
Please sir, can I have some more?
The FCA acknowledges there’s a problem with cost disclosure. It’s apparently working on a long-term fix.
Indeed the potential for things to get better is another siren call that’s attracted me to the sector.
After all, one way to (try to) profit as an active investor is to head in the direction that everyone else is running from.
And if institutions are dumping assets for non-economic reasons then consider my interest piqued.
However to profit from any David vs Goliath heroics, we must be able to implement our cunning plans.
That is: we actually have to buy the things.
And that isn’t always easy when regulators and platforms are ‘protecting’ everyday investors from getting into some of the hairier trusts.
All’s fair in love and discounted investment trusts
For instance CityWire reported in April on how AJ Bell was restricting clients from buying shares in the investment trusts Chrysalis (ticker: CHRY; I hold) and Bluefield Solar Income (ticker: BSIF).
AJ Bell did this following ‘fail’ assessments in a fair value review conducted by its external consultant, 360 Fund Insight.
CityWire reports:
Investors could phone through a transaction and still pay the online charge of £5 rather than the normal phone fee of £25, a spokesperson for the firm said.
Customers of AJ Bell complained they had also been prevented from buying Digital 9 Infrastructure, Cordiant Digital Infrastructure, and Amedeo Air Four Plus after those too failed the assessment.
Investors are furious they are being prevented from buying closed-end funds trading on wide discounts that they regard as good value, and believe the low share prices offset any potential concerns over performance and costs.
And no wonder! What’s the point of enabling active investors to trade securities on your platform if you’re going to overrule their own assessment of value with one you prepared earlier?
I also don’t understand why clients could phone through orders, but not make the deals online? Perhaps a broker on the other end probes their suitability (or sanity). Better answers in the comments, please.
As for the ‘fair value’ issue though, this appears to be fallout from the Consumer Duty regulation I noted earlier.
Fair dealing
Platforms and brokers say Consumer Duty means they must alert customers who are at risk of poor returns and help them to make better decisions.
According to CityWire, price, performance, leverage and liquidity are all factors determining whether investment trusts are regarded as ‘fair value’.
However you don’t need to be Warren Buffett to understand those very same factors could make a trust potentially cheap, and be what’s attracted bargain hunters in the first place.
Moreover if I’ve got a longer time horizon than whoever sells me their shares – and/or if I’m happier to put up with liquidity issues or some other drawback – then my idea of ‘fair value’ may be legitimately different from a sellers’ – or even from a platform’s hired consultant.
The point of markets is that opinions differ. That is how we really do arrive at fair value.
It seems unlikely the legislation means to funnel everyone into a consensus-satisfying Nasdaq tracker fund – or whatever else is the winning investment du jour.
But a glib reading could suggest otherwise.
Set up to fail
AJ Bell is not alone in protecting investors from potential money-making opportunities. It’s happening all over the place.
For example the same CityWire article notes:
Hargreaves Lansdown has also restricted investors from buying Digital 9 Infrastructure, Cordiant Digital, and Amedeo Air Four Plus until they pass a questionnaire showing they have the understanding of ‘complex investments’.
While Cordiant and Amedeo are listed on the London Stock Exchange’s specialist fund segment, Digital 9 is not – though it is still viewed as ‘complex’.
Closer to home, Monevator Moguls member Mirror Man found a ‘Complex and Levered Product’ label being applied by Interactive Brokers to various investment trusts, hindering them from buying shares even in a giant trust like Brevan Howard’s £1.3bn BH Macro. (Ticker BHMG; I own).
In the Monevator comments, Mirror Man explained the platform won’t allow them to add to their existing holding of BH Macro, though it will let the shares be sold.
To buy more, Mirror Man must pass a test covering stuff such as ETNs, warrants, discount certificates, and leveraged ETFs, by answering questions like:
Assume a warrant on ABC share has a strike of EUR 40.00 and an exercise ratio of 0.1. The share is trading at EUR 45.00 and the warrant at EUR 0.70, resulting in a leverage of 6.4. If the share price were to increase to EUR 50.00 while the time value of the warrant remained constant, which of the following statements is true?
But I’m here to tell you nobody should need to be able to answer such questions to assess whether they should have money invested in BH Macro.
That’s because as a private investor, having such knowledge won’t help you judge the trust’s virtues – or otherwise.
What was the question again?
BH Macro is essentially a black box from the outside when it comes to the complexities of its trading models (though it does disclose plenty of other information in regular updates to the market).
Its fees are high, too.
These are two very good reasons to be cautious before investing in this trust.
In contrast, understanding how warrants are priced won’t help you assess the pros and cons. No more than I need to know how a jet engine is serviced in order for me to book the best flight to New York.
More relevant questions would focus on customer-specific issues. They might assess your general investing know-how, your level of experience in terms of time and range of investments, your capacity to take losses – and, crucially, your willingness to sign away any liability should losses occur.
Many readers will be familiar with the ‘sophisticated investor’ assessments sometimes required when investing into unlisted companies. Those seem to me more fit for purpose.
It’s behind a sign-up wall, but CityWire published the answers to a Hargreaves Lansdown questionnaire concerning complex products. This test – or at least the portion CityWire shared – does at least seem more in the ‘sophisticated investor’ vein than esoterica about trading instruments.
Anyway Hargreaves reportedly pushed back, saying that investors being able to access a cheat sheet could provoke the ire of the FCA.
So CityWire removed them but it left the quiz up, with heavy hints about how to answer.
Who is protecting who?
Why help Hargreaves’ customers get through their unasked-for homework?
I’d echo the CityWire journalists, who wrote:
We share the frustration of readers about the classification of some investment companies and trusts as ‘complex’, and the assumption that their investors need protecting.
The Financial Conduct Authority’s consumer duty rules require share-dealing platforms to flag ‘complex instruments’, which they can implement in their own way.
While Hargreaves requires you to pass the questionnaire, AJ Bell, Interactive Investor and Fidelity simply ask investors to certify that they are aware of the risks.
To my mind this cross-platform subjectivity is another unjustifiable aspect to the whole business.
It would be one thing if there were a centralised list of what trusts were in or out for retail investors. I’d still argue against such a mandate, but at least there’d be consistency.
But as things stand I can – and have – bought BH Macro on one of my platforms without any fuss, while arbitrarily Mirror Man cannot on theirs.
Does that seem right?
Of course being a person whose paranoia has me using half-a-dozen different platforms, I suppose in practice this ‘will they, won’t they?’ uncertainty works for me, compared to a blanket all-platform banning from on high.
That’s because I can usually find what I want with one of my brokers.
Nevertheless a simple approved list of trusts would be more logical. The current approach smacks of platforms playing chicken – if not arse-covering.
When you come at the king…
Talking of illogical, last summer even saw Fidelity suspend investments into RIT Capital Partners (ticker: RCP, and yes I hold). This is the OG granddaddy of wealth-preserving investment trusts – hitherto seen as a prudent place for middle-aged duffers to park the proceeds from daddy’s estate sale.
True, RIT has struggled recently as the market has become wary about unlisted holdings. RIT has a chunky (and hitherto profitable) allocation to private companies, and its discount blew out to near-30%.
But again, should platforms be assessing the risks and rewards on offer with such a security? Let alone trying to assess via questionnaires whether their customers could do the job of investment trust employees should the latter come down with the lurgy?
As Mirror Man said in their comments: “I want my broker to provide me with a service (order execution), not masquerade as a financial regulator.”
As things stand it’s possible that by making it harder to invest in trusts, platforms are exacerbating the discounts, given that everyday retail investors are the natural buyers of a trust like RIT Capital.
Passive aggressive
Incidentally, any passive investors who made it this far might be thinking it’s all another reason they’re best out of active investments (which most will be).
Yet the very same regulations also prevent you from buying most US-listed ETFs on the UK platforms.
I know there are ways around this, such as if the ETF has issued a Key Information Document (KID).
Individuals who can declare themselves as professional investors can buy non-UCITS ETFs, too.
But again, anyone can happily buy thousands of other US assets – in ISAs and SIPPs even. Dodgy meme stocks are no problem. Is restricting access to (sometimes larger and cheaper) US ETFs really logical?
Happily it seems the regulator is having second thoughts about this one.
From ETF Stream:
ETFs domiciled in the US could be granted equivalence under the UK government’s Overseas Fund Regime in a move that would open the market to US-listed ETFs.
The Financial Conduct Authority launched a consultation with asset managers last December on how products should be recognised under the post-Brexit framework.
The UK government granted equivalence for all UCITS vehicles in the European Economic Area (EEA) in January, with US-listed ‘40 Act’ ETFs also being considered.
Any move would need to be approved by the UK Treasury deeming the regulatory regime for the overseas fund to be equivalent to the UK.
US-listed ETFs are not currently available for sale under EU law as they do not publish certain documents required by the European and Securities Markets Association.
Finally, potentially, a Brexit benefit!
It’d be a win-win for all of us.
Who’d be a regulator?
Honestly I do have sympathy for the regulators – and for the platforms trying to keep up with them.
And I fully understand the push to make the financial services sector one where service is more for the benefit of customers than for employees.
The disinfecting sunlight cast upon high-fee financial advisors in recent months is overdue, for example.
On the other hand, regulators shouldn’t stop people who know what they’re doing – or who are willing to accept the consequences anyway – from spending their money as they see fit.
And I think the same should hold for over-zealous and/or over-cautious platforms interpreting how the regulatory wind is blowing.
Consider the FCA’s semi-reversal on Bitcoin ETFs – vehicles now running perfectly smoothly in the US.
The FCA’s revised position is:
These products would be available for professional investors, such as investment firms and credit institutions authorised or regulated to operate in financial markets only.
But is barring access to Bitcoin ETFs the best way to protect retail investors?
Think about the long history of crypto platforms being looted or otherwise falling over. The booms and busts of alt-coins. The legions of crypto grifters pumping and dumping daily across social media.
Not to mention the mishaps that can occur when people attempt self-custody of their own crypto assets – including sending millions of pounds worth of crypto to landfill.
There are even micro-cap Bitcoin miners listed on the AIM market which are freely available for trading.
You can have at all those, no problemo. But apparently only professionals can be trusted to put £1,000 into a bog-standard Bitcoin ETF.
The fault is in ourselves
Running a blog about personal finance and investing, I see all the scammers and shysters.
Indeed I spend the best part of an hour every day wading through their spam in the Monevator comments and email.
Also, for better or worse our society has moved towards a compensation culture.
Many people now expect to be bailed-out when their decisions don’t work out – but left well alone when they do. It’s hard to square.
So regulators and platforms surely have a difficult time of it.
Still, given all the straight-up larceny around, I don’t see that restricting informed and hands-on investors from buying shares in legitimate companies should be any regulator’s top-priority.
Investment trusts have a duty as listed businesses to accurately report their activities to investors. All information properly required should be made available. And platforms should flag it where appropriate.
Fine – if we must have a checkbox with links to the downside and the risk of ruin then on our heads be it.
Companies shouldn’t lie to us or wantonly mis-sell products. Regulators can valuably tackle those issues.
But frankly, if after being given the relevant data somebody wants to invest their money with a legal but ‘reassuringly’ expensive high-fee advisor say – perhaps because they like glossy brochures and feeling special – then that’s their business as far as I’m concerned.
And given that, I obviously believe we should also be able to buy whatever (legal) securities we want.
Regulation versus prohibition
If after being given the appropriate warnings I want to buy a triple-levered ETF shorting the Nasdaq then let me.
Just like if I want to buy a value pack of ten beers and 40 fags for the evening.
It’s not advisable, but it’s my choice.
I’m not making some specious point here about enabling UK investor’s money to ‘support the London Stock Exchange’ or ‘channeling money into productive investment’.
I just think it’s a matter of basic morality and freedom in a capitalist system.
Sure, have gatekeepers for mainstream products.
But don’t let them become wardens hampering the minority of us engaged investors who actually do our research – and who are ready to live with the consequences.
What do you say readers? How would you regulate if you were given the awkward chalice? Let us know in the comments below.
- Mifid (Markets in Financial Instruments Directive) and PRIIPS (Packaged Retail Investment and Insurance-based Products [↩]
Surging inflation is one of the nastiest, portfolio-crumbling threats investors face – not least because defending against it is as difficult as defeating dry rot. The last few years have taught us a great deal about what does and does not work, so here’s our updated guide on the best inflation hedges.
Note: All investment returns quoted in this article are annualised real returns.1
How to hedge against inflation
There are three asset classes worth considering as inflation hedges:
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.
Not a single asset class (including our three prospects above) comfortably fulfils our definition of a ‘good inflation hedge’. I’ll explain why below.
And so sadly 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 is a less attractive option for early- to mid-stage accumulators than for near-retirees and decumulators.
When you’ve decades to go, concentrate on beating inflation over time with a strong dose of global equities. 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: index-linked gilts
If you buy individual index-linked gilts (not index-linked gilt funds or ETFs) then they will hedge against UK inflation provided you hold them until maturity.
For example, if you put £1,000 into the index-linked gilt UKGI 1.25 11/27 – and hold until maturity – then your £1,000 will grow in line with RPI, until your capital (or principal) is returned to you on the bond’s 22 November 2027 maturity date.
On top of that, if you reinvest your RPI-adjusted coupon (interest) payments into the bond, then you’ll approximately earn the current real yield of 0.11% per annum.
That is far from an awesome return. But it’s better than the negative rates inflation-linked bonds were earning until recently.
And at least you know that money invested on this basis will keep pace with inflation.
For Brits, this is the best inflation hedge you can buy in the sense that it will reliably protect your purchasing power against official inflation.
That’s because no other investment is index-linked to a UK inflation measure.
Caveats a go-go
If you sell your individual index-linked gilt2 before maturity then you may make a capital loss (or gain) due to price risk.
Price risk is the risk that the price of your bond drops as its real yield changes before maturity.
If bond yields spike hard and fast enough, then a linker’s price can fall so far that you’re not adequately compensated by the bond’s inflation-linking features.
But – and forgive me for going on about it – bond mechanics mean you can defuse any price risk simply by holding your bond to maturity. (You must also reinvest your coupons in a timely manner to earn the real yield on offer when you bought in, too.)
Price risk is the reason why inflation-linked funds and ETFs are not a guaranteed inflation hedge.
Bond managers typically sell their securities before maturity in order to maintain their fund’s target duration.
As interest rates took off in 2022, managers were therefore booking capital losses as prices fell in response to rising bond yields.
The longer your fund’s duration, the deeper your loss. Short-duration inflation-linked funds were less badly damaged, but they still didn’t keep up with inflation in 2022 and 2023.
For more on how to buy and use individual index-linked gilts, read up on how a rolling linker ladder works and learn how to build an index-linked gilt ladder.
If you maintain part of your portfolio as a ladder of individual index-linked gilts then you can sensibly leave your inflation-hedging efforts at that.
But…
Vanguard points out that index-linked bonds aren’t likely to prop up the rest of your portfolio when the money-munching monster runs amok.
That’s because short-term index-linked bond yields are so slim, that our allocation can’t be expected to do much more than return your money with a few inflation-adjusted sprinkles on top.
(Note, Vanguard talks about US TIPS. But the same is true – perhaps more so – for inflation-linked gilts.)
More concretely, linkers fall short of our ‘deliver reasonable long-term returns’ criteria.
So let’s push on and look at the inflation-hedging properties of commodities.
Inflation hedge: commodities
Numerous research papers point out that commodities sometimes deliver exceptional returns in the teeth of inflationary pressure.
It certainly makes sense that commodities should serve as some kind of inflation hedge, given that the cost of raw materials is often one of the booster rockets strapped to accelerating prices.
That said, most of the research examining the issue is problematic. Usually because the data doesn’t reflect investable commodity indexes, or is quite short-term, or is US-oriented, and so on.
Nonetheless, your heroic Monevator correspondent partially mitigated his own cost-of-living issues by spending time digging up relevant broad commodities data and plotting it against UK inflation – instead of blowing his cash on having a life. You’re welcome.
My conclusion?
Commodities are a partial inflation hedge.
The asset class has delivered spectacular returns at times as inflation begins to stir.
Often the lift-off in commodities presages escalating UK inflation further down the road.
But by the time headline rates are hurting our pockets, commodity prices are often tumbling back down again.
Over a one-year period, commodities are actually negatively correlated with UK inflation (1934 to 2022).
However, commodities outdid the other major asset classes when inflation was above-average (1934 to 2022).
Average annualised returns during inflationary episodes were:
- Commodities: 4.5%
- UK equities: 3.6%
- Gold: 1.8%
- Gilts: -2.2%
- Cash: -1.9%
Meanwhile, the historic annualised real return of commodities was 4.5% (in GBP) across the entire time period from 1934 to 2022.
Thus an allocation to raw materials historically fulfilled the ‘deliver reasonable long-term returns’ part of the brief.
And they have generated extremely high, inflation-beating nominal returns at times.
But commodities cannot be said to work reliably as an inflation hedge. You can shape them around your portfolio like an armoured plate, but you can’t expect them to deflect every inflationary bullet.
Finally, the USP of commodities is also its biggest weakness.
Commodities are useful primarily because they’ve been historically negatively correlated with equities and bonds. And equities and bonds tend to fail together during bouts of galloping inflation.
But commodities can be a terrible drag when the commodity asset class suffers a bear market. The beating taken by commodities between 2008 to 2020 would have shaken the resolve of even the most fanatical inflation-phobe.
We recommend reading the recent Monevator commodities series and researching the asset class yourself before committing any cash.
Inflation hedge: gold
The case for gold as an inflation hedge is similar to – but weaker than for – commodities.
At best, gold’s performance can only be appropriately measured from 1968. That’s because it was caged by government regulation before then.
Monevator investigated the behaviour of gold versus UK inflation when we asked: is gold a good investment?
The long and the short of it is that gold is historically uncorrelated to inflation. You can’t rely on the yellow metal as an inflation hedge.
So why are we even talking about gold? Because it is also negatively correlated with equities and gilts. So occasionally the shiny stuff’s good years have coincided with bouts of unexpected inflation.
Gold just bobbed ahead of inflation in 2022 and 2023. It also had a reasonable 1970s during that stagflationary era.
Golden years
The US-orientated, 2021 research paper The Best Strategies For Inflationary Times stated that gold turned in average returns of 13% during four inflationary regimes post-1971.
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 long-term GBP annualised returns of gold are hard to pin down. Take your pick from:
- 1900-2022: 0.8%
- 1968-2022: 3.5%
- 1975-2022: 1.5%
Ultimately, gold is a total wildcard.
It may work during an inflationary crisis: the charts show it soaring like a NYC pencil-tower during some years in the 1970s.
You’d always want gold in your portfolio if you could rely on it doing that.
But then again, gold suffered a 19-year horror show from 1980 to 1999. Losses peaked at -78%.
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 gold as an inflation hedge is weak.
Inflation hedge: real estate
Property is often named on the roster of potential inflation hedges. However, the renowned investment researchers 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, we think commercial property is best thought of as an inflation-beating strategy. As opposed to an inflation hedge.
Dimson, Marsh, and Staunton 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.
And 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 in The Best Strategies For Inflationary Times. 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 according to Neville et al. These were 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. Which offer a diluted version of the pure form examined in the paper.
Once again our hopes are stymied by the gap between backtested 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: 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.
Here’s a recap of how correlation metrics work:
- 1 = Perfect positive correlation: when one thing goes up so does the other
- 0 = 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.
But the even 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 – until recent years – inflation had been quite benign since the late 1980s.
- 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 via an iShares ETF with the ticker WOOD. (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!]
Inflation hedge: trend following
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.
Moreover 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 the best of luck to you. But 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 his 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 saving for retirement. 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.
You might also consider an allocation to broad commodities and even gold as modelled in our decumulation strategy portfolio.
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