January 27, 2023
Do certain asset classes hedge against inflation better than others? A recent Vanguard paper suggests that commodities may add an outsized safeguard against unexpected inflation.
In the paper Commodity Investing and Its Role in a Portfolio, Anatoly Shtekhman, head of global advised portfolio construction, Fei Xu, head of alternative and multi-asset investments in Vanguard Quantitative Equity Group (QEG), Victor Zhu, senior investment strategist in the Investment Strategy Group, Ziqi Tan, investment strategy analyst in the Investment Strategy Group, and Stefan Sevi, assistant portfolio manager in QEG, explore the three primary functions of commodities: diversification, returns, and hedging against unexpected inflation.
Inflation isn’t an entirely unanticipated occurrence. Forward-looking financial markets expect a certain level of inflation and factor it into the asset prices they set. It’s when markets are shocked by unanticipated events—say a surge in energy prices or persistently high demand for goods—that unexpected inflation occurs. And those elevated levels of inflation can erode investor portfolios.
Unexpected inflation can be particularly damaging for retirees or other investors with a short-term investment horizon.
To combat such risks, several portfolio strategies can provide investors with strategic exposure to inflation-sensitive assets. These include Treasury inflation-protected securities (TIPS) and commodities.
“Investors with a longer time horizon may fare well with equities as an inflation-fighting tool, but people who are concerned about purchasing power over the next five years may want to consider a strategic exposure to commodities futures,” said Xu. “Commodities prices in general trend upward as the cost of consumer-driven commodities like food and gas rise, which can lead to higher unexpected inflation.”
Commodities tend to behave differently than traditional asset classes, especially when commodity price shocks are driven by unexpected changes in supply. (Consider the impact of wheat and oil disruption after the Russian invasion of Ukraine, or the extended shutdown of Chinese factories amid a long-standing national zero-COVID policy.) Vanguard research found that commodities had an inflation beta that fluctuated between 6 and 9 over the past three decades, the highest among all the asset classes the authors examined. This suggests that a 1% rise in unexpected inflation would produce a 6% to 9% rise in commodities. In short, a small yet strategic commodity position can offer an outsized safeguard for an overall portfolio.
“There is no silver bullet to fight inflation, but if short-term inflation hedging is the goal, historically, commodities have been an excellent choice,” said Shtekhman.
That said, it’s worth noting that commodities aren’t the only tool in the inflation-fighting toolbox, especially for investors with a longer time horizon. They may be better served by a more traditional mix of stocks and bonds, where equity risk premium will likely outpace inflation and deliver real return over longer time periods.
TIPS are commonly used as inflation fighters but can be limiting in terms of capital efficiency. They have a relatively low inflation beta, which means that only the TIPS portion of a portfolio is inflation-hedged. An allocation to commodities, meanwhile, can hedge a significant amount of a portfolio, even beyond the commodity portion. “A small addition of commodities can be a more efficient diversifier than the addition of TIPS, which means the rest of your portfolio can be unlocked to pursue other strategic initiatives,” said Shtekhman.
The energy sector also has a significant relationship with unexpected inflation, which makes it another commonly used inflation hedge. However, in addition to its very high correlation (beta) with the broad equity market, the sector also has the potential for idiosyncratic company risk (an accident on a drilling platform, for example), variations in corporate capital structure and management quality, and other factors that can mute the full impact of the relationship.
Source: Bloomberg. Data are based on information from BCOM, the S&P GSCI, the Russell 3000 Index for U.S. equity, the U.S. Aggregate Bond Index for U.S. bonds, the FTSE REIT Index, the BCOM Gold Index, and the FTSE 3-Month Treasury Bill Index from January 1984 through June 2022. Non-U.S. equities data are based on the MSCI ACWI x USA Index from December 1987 through June 2022. Non-U.S. bonds data are based on the Bloomberg Global Aggregate ex-USD Hedged Index from January 2013 through June 2022. U.S. TIPS data are based on the Bloomberg U.S. Treasury Inflation-Protected Securities Index from March 1997 through June 2022, short-term TIPS data on the Bloomberg U.S. 1-5 Year Treasury Inflation-Protected Securities Index from September 2002 through June 2022, and energy equity on the S&P 500 Energy Index from September 1989 through June 2022.
Commodity returns are pre-tax, making them tax-inefficient versus other asset classes.
While the optimal percentage of commodities will vary based on different inflation environments, economic conditions, and investor risk tolerance, a large position isn’t needed to build an effective hedge against inflation. The following examples show how commodity allocations can change in differing inflation conditions, as constructed by the Vanguard Asset Allocation Model (VAAM) in combination with time-varying asset return expectations as generated by the Vanguard Capital Markets Model ™ (VCMM). As inflation rises, so does the allocation to commodities.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of May 5, 2022. Results from the model may vary with each use and over time. For more information, please see the Notes section.
Investing always has trade-offs and risks, but the authors maintain that commodities can offer a short-term solution to the inflation problem. “When investing in commodities, you’re creating a tracking error against your strategic asset allocation to gain access to inflation hedging,” said Shtekhman.
Investors concerned about unexpected inflation can develop inflation-hedging goal-based portfolios with varying commodities allocations that respond to changing economic forecasts, as displayed above, or those that target a specific beta by using the Vanguard goal-based portfolio construction methodology. With either method, “a little bit of a commodity allocation can go a long way,” said Xu.
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.