Great Expectations: A Tactical Asset Allocation Framework for Diversified Real Asset Portfolios

Abstract

Diversified real return strategies are multi-asset portfolios structured to possess a heightened sensitivity to inflation relative to traditional stocks and bonds. The majority of such strategies focus on a single measure of inflation, the Consumer Price Index. However, a more comprehensive way to construct inflation-sensitive portfolios is in terms of expected and unexpected inflation, the latter defined as the difference between a particular measure of inflation expectations and realized inflation. To that end, in this article, the authors describe an investment framework that dynamically classifies each type of inflation as belonging to one type of state: a stable state, in which inflation continues its longer-term trend, and a deviant state, in which expected or unexpected inflation departs significantly from its longer-term average. The authors show how the framework can be used to build portfolios using information from both stable and deviant states to outperform realized inflation through different market environments.

TOPICS: Portfolio construction, legal/regulatory/public policy, quantitative methods