Fighting the Next Battle: Redefining the
Inflation-Protected Portfolio

Abstract

The debate about the direction of future inflation and the damage it can cause to a portfolio has become increasingly fraught of late. The massive fiscal and monetary expansions deployed in response to the global financial crisis have prompted many investors to think about how vulnerable they are to an inflation shock, and thus how best to protect their portfolio in the event such a shock occurs. Many have rushed headlong into assets generally considered to be strong inflation antidotes, such as gold and inflation-protected bonds. Unfortunately, however, little consensus and much confusion exists about how best to protect against inflation risk. While many different assets could potentially provide some protection against inflation, their ability to do so as well as their prospective cost varies, particularly when measured in terms of the expected returns they provide compared to what they are replacing in the portfolio. Also, arbitrarily incorporating one or more of these assets could markedly shift the otherwise carefully constructed risk profile of the portfolio. Because investors’ liabilities, risk tolerances, and portfolio objectives differ, a one-size-fits-all inflation protection formula that would be “right” for all investors is unlikely to be found. In this article, Ruff and Childers attempt to clear up some of the confusion surrounding these issues. They aim to provide insight into the tools available to protect against inflation risk and how an inflation-hedging strategy might be best implemented in light of the investor’s broader investment objectives.

TOPICS: Portfolio construction, VAR and use of alternative risk measures of trading risk, exchanges/markets/clearinghouses