Product and Strategy Notes: Which Asset Classes are the Best Inflation Hedges?; Gold Funds in Canada; IndexIQ New Products, Other News of Note and Pandemic Briefing

Which Asset Classes are the Best Inflation Hedges?

In response to the global recession, money supply growth rates are now at record levels in many parts of the world, which has significantly raised the chances of higher inflation in the years ahead. A number of recent research papers have re-examined the inflation hedging properties of different asset classes, and we will summarize their key findings here.

In "Inflation Hedging for Long-Term Investors", Attie and Roache of the IMF begin with two important distinctions: first, between the one year and longer term response of nominal asset class returns to an increase in inflation, and second, between an increase in expected inflation and an unexpected increase in inflation. From our perspective, for a long-term investor, the key issue is the evolution of longer term asset class returns to both expected and unexpected increases in inflation.

The IMF paper focuses on U.S. markets (where data availability is best) and examines the inflation hedging properties of cash (i.e., short term government securities), nominal return government bonds, equities, commodities and gold. They also include two SDR weighted indices of global equity and global government bonds (i.e., these country weights are proportionate to the weights of different currencies in the Special Drawing Rights basket). Let's start with the twelve month change in returns on different asset classes (between 1973 and 2008) in response to a one percent increase in the rate of inflation (i.e., the short-term response). The IMF finds that the two best hedges were commodities (a 9.87% increase in the GSCI index) and gold (a 6.87% increase). Cash was next best, with a fall of 57 basis points, followed by short term foreign bonds with a fall of 69 basis points. In contrast, domestic equities fell by (2.59%), global equities by (3.48%), domestic government bonds (all maturities) by (1.33%) and global bonds (all maturities) by (2.36%).

However, for long-term investors, the one year return response to a rise in inflation is less important than the five year response. As the IMF notes, "inflation shocks persist...After one year, the cumulative increase in price level is nearly three times the size of an initial shock, and after five years this has risen to five times." Hence, the long-run return response of different asset classes is critical. To capture this, the IMF calculates a long-run return multiplier, which essentially measures the extent to which the effects of an inflation shock are offset by a rise in nominal asset class returns. A multiplier of 1.0 signifies that the inflation shock is completely offset by higher asset class returns; greater than 1.0 signifies more than offset, and less than 1.0 (or negative) signifies a failure to fully offset the effects of inflation.

Short term Treasuries have a long-run multiplier of .8. Bonds suffer sharp relative declines in the short-run, but after a trough at three years begin to offset earlier losses through increases in yields relative to inflation, leading to a multiplier of .1. Equities show the worst performance, with a multiplier of (.2). Commodities are a more interesting case, with the strong short term response offset after about two years by a decline in economic activity (and commodity demand) triggered by higher inflation. As a result, their long-term multiplier is, like equities, (.2). The IMF paper does not present a longer term analysis of the gold multiplier.

Finally, two methodology points should be kept in mind about this study. First, as the authors acknowledge, the data it uses covers a period (1973-2008) when a number of structural breaks have occurred in the underlying economic series and return generating processes for some asset classes. Hence, the study's conclusions are at best rough estimates. This view is further reinforced by the second methodology observation, that some of the study’s methodology assumes normally distributed returns. While this makes the math tractable, it is at odds with actual distributions which have fatter tails (i..e, a greater portion of extreme returns).

Two other asset classes that are traditionally viewed as good inflation hedges are absent from the IMF study: real return (inflation-indexed) bonds, and commercial property. Two studies find that, in both the U.S. and U.K, inflation indexed bonds provide good hedges against inflation: "Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle" by Mamun and Visaltanachoti and "Asset Allocation with Inflation Protected Bonds" by Kothari and Shanken. However, neither study takes the IMF approach, and examines the long-term multiplier effect following an inflation shock. However, the IMF does raise the interesting point that historically, a rise in inflation has been associated with a longer-term rise in realized (ex-post) real interest rates, due to a sharp increase in the inflation risk premium required by investors in nominal bonds. However, they make no mention of whether this also applies to ex-ante real rates (indeed, if the real interest rate rise is all due to higher inflation risk premia, then ex-ante real yields would remain flat or decline). This is an important consideration for investors in inflation protected bonds, since a fall in real yields would boost their returns, while a rise in real yields would cause them to decline over the longer-run. On balance, given the decline in real economic activity associated with rising inflation, we think it most likely that ex-ante (expected) real yields - which drive inflation protected bond pricing - would decline (raising returns on this asset class), and that any increase in realized real returns on nominal government bonds is driven by an overestimation of the inflation risk premium relative to the rate of inflation that later occurs.

The inflation hedging benefits of commercial property is a far more interesting issue. First, it is complicated by data and market issues affecting both exchange traded and directly owned commercial property. These are sufficiently complicated that they will be the subject of a longer article in next month's issue. Second, the hedging benefits of commercial property also has a significant time-lag component. In the short-term, property rents are generally fixed (though revenue related retail rents and similar structures are an exception). However, as leases come up for renewal, they tend to catch up with inflation - though the extent of the catch up can be offset by the decline in economic activity caused by inflation. These issues are examined in another paper, "The Inflation Hedging Characteristics of US and UK Investments: A Multi-Factor Error Correction Approach" by Hoesli, Lizieri and MacGregor. In the short-run, the authors find little adjustment to an inflation shock; however, in the long-run, they find that in both the US and the UK property returns recover most (but not all) of the ground they lost - to put it in the terms used by the IMF, the multiplier is positive, but less than 1.0.

Last but not least, also absent from the IMF study is any discussion of timber as an inflation hedge. We would expect it to perform in a manner similar to commercial property. In the short term, timber producers' earnings and returns might decline following a rise in inflation, assuming costs rose faster than revenues earned on fixed price contracts. However, given the continuing (and completely uncorrelated) biological growth of timber, as well as the renegotiation of contract prices over time, we would expect timber to have a five year inflation multiplier close to 1.0 (though still below it because of rising inflation’s negative impact on aggregate demand growth).

So, to sum up: in the short-term, inflation-protected bonds, commodities and gold appear to be the best inflation hedges. Not far behind are short-term domestic and foreign government securities (with the performance of the latter driven by the difference between home country inflation and average inflation in major foreign bond markets). In the medium term, inflation protected bonds and short-term bonds continue to do well. We suspect this also applies to gold and timber. Commodities, however, lose some of their hedging benefits if higher inflation leads to lower real economic activity. On the other hand, as is well described in another new paper ("The Three Epochs of Oil" by Dvir and Rogoff), declining demand can be more than offset by changing commodity supply conditions, as happened in 1973 and 1979 - so the medium term decline in commodities' inflation hedging benefits is not automatic, and in fact may not occur. Finally, any long-term decline in commodities returns may be offset by better long-term hedging performance in commercial property, where adjustments to higher inflation only occur over time.

New Products

In Canada, a number of new gold funds have been announced, by Claymore and Sprott. They will join the Central Fund of Canada (which invests in gold and silver bullion) and the BMG Bullion fund (which invests in gold, silver and platinum).

In the United States, IndexIQ, recently filed a registration statement for even more ETFs that track hedge fund indexes, including equity market neutral, global macro, distressed debt, managed futures, and a number of arbitrage strategies. In March, its first hedge fund tracking ETF product (QAI) began trading. It invests in an underlying portfolio of ETFs to replicate the returns of a broad hedge fund index. We are not enthusiastic about QAI because the index it tracks includes a wider universe of underlying hedge fund strategies than those that seek to deliver alpha with a low correlation to returns on broad asset classes that can be obtained at a lower cost by passive index investors. Because of their more granular strategy segmentation, these new products may be more attractive. We will monitor their performance after they start trading, and write about them again. However, also included in the IndexIQ prospectus was a product that we find even more interesting and potentially useful in investor portfolios: an ETF that tracks US CPI inflation. We look forward to analyzing it in more depth once it has passed through the SEC and actually launched on the market.

Other News of Note

It was nice to read JP Morgan's new research note on the virtues of investing in timber as an asset class ("Investing in Timberland: Another Means of Diversification" by Jeff Mortimer).
We note that art prices are off more than 35%, according to the Mei Moses Index, confirming our long-held view that investing in art would provide little in the way of diversification benefits (given the strong linkages of many buyers' wealth to GDP and equity market performance).
We couldn't help but notice the comment by Bob Barker of Credit Suisse Asset Management in a recent FT article ("Multi Challenges for Asset Managers" by Pauline Skypala). He noted there is rising demand for from clients for advice on global asset allocation. Don't forget to recommend us to your friends and colleagues!
In "What Matters More for Entrepreneurial Success: Skills, Personality, or Luck?", Liechti, Loderer, and Peyer apply econometric techniques to a database of Swiss entrepreneurs and conclude that "luck is about two to three times as important as the other two success factors." That certainly agrees with our observations over the years, across a wide range of countries and businesses. But the winners don't want to admit it, and coming from the losers it sounds too self-serving.
Another FT article ("Europe's Rich Rush for Hedge Fund Exits" by Deborah Brewster) noted that "rich Europeans, who were the first to invest in hedge funds and once comprised the majority of investors, have been the first to exit in the downturn", citing a new BNY Mellon study. Apparently Asian investors weren't far behind. Over the past three years, individual investors' share of hedge fund assets fell from 67% to 57%. From our perspective, this seems logical, as investors realize that (a) many expensive "hedge fund" strategies were actually directional bets that contained a lot of asset class beta they could have obtained much more cheaply from other sources; (b) hedge fund compensation structures were not only expensive, but created significant principal/agent conflicts, due to fund manager's ability to wind up the fund rather than spend years working only for fees to regain a high water mark; (c) they now recognize that for many strategies, compensation for bearing either liquidity or extreme tail (insurance) risk accounted for a greater share of returns than they initially believed; and (d) more and more uncorrelated alpha strategies are available at much lower cost in the form of mutual and exchange traded funds.
The implications of these fund flows are further fleshed out in "Toward Transparency and Sustainability", an interesting new report from IBM Global Business Services on the future of the investment management industry. Depressingly, their survey data paints a picture of an industry that is not only out of touch with its client's top needs, but also believes itself to be falling short in areas that are critical to its future, like managing systemic risk, implementing new technologies, and eradicating inefficiencies in its business processes. IBM concludes that "the days when the financial markets industry could make large sums of money by capitalizing on pockets of opacity and high leverage are over." In its place, they forecast greater division of firms into three strategic groups: providers of beta returns, providers of uncorrelated alpha returns, and advisers. It is a vision we've shared for years, the realization of which is long overdue and cannot help but benefit investors.
Last but not least, we occasionally come across an academic study that leaves us chuckling. In "The Demographics of Fund Turnover", Christoffersen and Sarkissian "document that demographic factors influence mutual fund turnover." Since turnover adds to fund costs and therefore detracts from returns, we were curious about their findings. "These factors include managerial experience, location, education and gender. On average, funds in financial centers trade more, but this excess turnover declines with experience. While most extra trading is concentrated among less experienced managers in financial centers, they do not outperform inexperienced managers located in smaller cities." The authors also found that "managers in financial centers increased their trading after good performance. This result was particularly strong for less experienced more educated male fund managers investing in growth stocks and located in New York." Based on years of observation, we are certain that this is a conclusion many a New York bartender would strongly support!

Pandemic Influenza Briefing (Previously Sent as Email - May 1, 2009)

As long-time subscribers are well aware, for many years now, we have regularly reviewed the asset class valuation and return impact of a "wild card" influenza pandemic scenario, and in particular, a step-function increase in the transmissibility of H5N1 - so called "bird flu." Given the headlines over the past few days about a new strain of H1N1 influenza that is apparently spreading from Mexico, we have prepared this short background memo for our subscribers. It covers three issues: (1) Background on influenza, and its potential economic impact; (2) Warning Indicators to monitor; and (3) Our estimate of the possible implications of H1N1 Mexican influenza for asset class valuations and returns over the next twelve months.

Background on Influenza

Influenza viruses are classified first by type (A, B, or C); then by subtype, and then by strain. Most influenza viruses, including the most recent Mexican "swine flu" and so called "bird flu" (or, more technically, "Highly Pathogenetic Avian Influenza" or HPAI) are type A influenzas. Viruses are subtyped based two of the eight strands of RNA found on their genome: HA (which affects the production of the glycoprotein hemagluttin) and NA (which affects the production of the glycosylate enzyme neuraminidase). Hence, HPAI is of the subtype H5N1, and the latest Mexican swine flu is of the H1N1 subtype. Currently, 15 HA subtypes and 9 NA subtypes have been identified. These subtypes are further classified according to their so-called "strain", which is based on the genetic heritage of the different strands of RNA they contain. In between periodic outbreaks in humans, the world's population of influenza viruses resides in the intestinal tract of waterfowl, which are usually not affected by them. In contrast, human influenza viruses have a marked preference for the upper respiratory tract. Hence, in order for an avian influenza virus to attain the capability to infect humans, its genome must change, so that it develops a preference for attaching itself to the human upper respiratory tract rather than the intestinal tract of aquatic birds. There are different theories about how these changes happen. Some treat them as random accidents, produced by the tendency of the influenza virus to replicate itself in great numbers, but with poor fidelity between generations (i.e., to randomly mutate different aspects of its eight RNA strands).

Another theory is that the creation of new virus types is facilitated when a host becomes infected with more than one type of influenza virus. Pigs are the prime suspect for this mechanism, because their intestinal tracts are similar to waterfowl (in that influenza viruses that bind to the latter can bind to the former), while the upper respiratory tracts are similar to humans'. Hence the reassortment of influenza RNA in pigs can produce new "swine" viruses with both avian and human characteristics. Yet another theory posits that the evolution of the influenza virus is driven more purposefully, in that variants with higher fitness (i.e., ability to attach to a host, replicate, and be transmitted) are (through some mechanism) selected as different subtypes recombine (e.g., this seems to account for the rapid spread of antiviral resistance through multiple types of flu viruses around the world in the past two years).

Three different terms are critical when it comes to assessing the danger posed by an influenza virus. The first is its transmissibility, or the ease with which it is passed from human to human (abbreviated as H2H), without any common exposure to aquatic or other birds (e.g., chickens have become a reservoir for HPAI) or pigs. The second is referred to as either the virus's "virulence" or its "pathogenicity." Both of these terms refer to the degree of sickness (and, ultimately, the death rate) produced by a given strain of influenza. Finally, you may hear the term "tissue tropism" in the same context as virulence or pathogenicity. This refers to the specific body organs that are affected by an influenza virus. The typical influenza virus affects the upper respiratory tract. It kills via a number of mechanisms, including aggravation of preexisting respiratory and cardiopulmonary conditions, and weakening a host so as to allow the development of a secondary bacterial pneumonia infection. Less often, an influenza virus can directly cause a type of viral pneumonia (which, unlike bacterial pneumonia, cannot be treated with antibiotics). This was the main way that the 1918 pandemic influenza (which was also of the H1N1 subtype) killed its victims, via rapid lung inflammation and associated haemorrhaging. What has made many medical professionals particularly fearful of H5N1 has been the evidence of its broad tropism, with apparently severe effects on a range of organs, including the brain, liver, and intestinal tract. Last (but certainly not least), history has shown that in most cases (1918 being an exception) there is an apparent evolutionary tradeoff between transmissibility and virulence -for example, while easily transmissible, seasonal flu is not particularly deadly; in contrast, while quite virulent, H5N1 has thus far shown (in humans) very weak transmissibility.

Let us now turn to the economic impact of influenza. One thing to keep in mind is that our knowledge of these issues is limited by the weakness of the underlying data we have to work with. For example, records from the 1918 pandemic are quite poor. More surprising is that even more recent data has significant weaknesses. For example, there is an ongoing controversy about the measurement in the United States of "flu related deaths." The narrower definition is based on influenza and pneumonia related deaths, leading to estimates of on the order of 36,000 annual deaths from seasonal flu in the United States. Yet on its website, the Center for Disease Control also offers a higher annual estimate (51,000) that also includes deaths from other causes (e.g., cardio-pulmonary and other respiratory diseases) that are aggravated by influenza.

One commonly used assumption is that each year in the United States, 15% to 20% of the population is infected with seasonal influenza. Based on a population of 306 million, this amounts to about 61 million infections per year. However, since the strains of seasonal flu in circulation are usually relatively mild, only 1% of infected people (about 610,000) end up being hospitalized. The highest hospitalization rates are typically found among the very young and the very old. Of those who are hospitalized because of influenza, roughly 8% die (which yields 49,000 deaths, or about 0.08% -- i.e., eight one hundredths of one percent -- of those infected, or 0.016% of the overall population). As noted above, data on the 1918 pandemic are limited. However, available estimates suggest that 675,000 people died in the United States, out of a population of about 103 million, for an overall death rate of about 0.66% of the population. Of those infected, an estimated 2.5% died. To put that into current terms, out of a 2009 population of 306 million, an exact repetition of the Spanish flu would lead to just over 2 million deaths.

However, many things have changed since 1918, and it is therefore highly unlikely that we would see such an exact repetition. Specifically, three factors seem likely to reduce the death rate from any pandemic. First, influenza vaccines exist today. To be sure, the 2008 vaccine does not appear to give any immunity to the latest Mexican swine flu. But vaccine development and production technology is sufficiently advanced that significant dosage volumes could be available about six months after the outbreak of a highly virulent new strain of influenza (there is a caveat here, which is that H5N1 is lethal to chicken eggs, which is a primary production technique for traditional influenza vaccines; however, the latest Mexican H1N1 strain has not been reported to be lethal to eggs). Second, much more sophisticated modeling methodologies are available to help devise policies (e.g., school closings and travel bans) that can help to limit the spread of a virus until large volumes of vaccine become available (of course, the caveat here is that globalization enables viruses to move around the world much more quickly, as we are seeing with the Mexican case). Third, modern medicine has more treatments at its disposal than were available in 1918, including antivirals (though rising levels of virus resistance to amantadine and Tamiflu have limited the effectiveness of this line of attack), mechanical ventilators, and antibiotics to control secondary infections. So it is unlikely (though not impossible) that we would again see the high death rates associated with the 1918 influenza pandemic.

Warning Indicators to Monitor

Thus far, based on available media reports, the Mexican swine flu does not appear to be highly virulent. The cases outside of Mexico appear to have been mild, with few hospitalizations required and no deaths. However, the data from within Mexico paint a different picture, with more than 143 deaths now reported. Since we don't have an estimate of underlying infection rates (which are at best very rough, even under ideal conditions), we can't reach any conclusions about the meaning of this figure. Moreover, we have very little information on the cause of death - though the good news here is that there are no reports of unusual tropisms - apparently, deaths are caused by traditional (for flu) respiratory tract complications (and Mexico City's high level of pollution and pre-existing respiratory conditions would logically elevate its death rate from these).

That said, we are looking for the following warning signs that this outbreak represents a more serious threat than it now appears to be:

Reports that the Mexican swine flu affects other organs - e.g., that it is neurotopic, or that it affects the digestive tract, liver or kidneys.
Also with respect to virulence, we are looking for any reports of coinfection (e.g., in swine) with Mexican H5N2 poultry influenza, which was associated with heart, pancreas and kidney tropism. Similarly, we are looking for any reports of Mexican swine H1N1 reaching Indonesia or Egypt, where H5N1 infections in poultry (and possibly other animals) have reached high levels (it is no coincidence that two of the United States premier infectious disease research organizations - Naval Medical Research Units 2 and 3, are, respectively, deployed to Indonesia and Egypt). The analogy we have in mind is 1918, when the initial mild wave of flu infections was soon followed by a subsequent wave of much more serious infections (which could have been caused by reassortment or recombination with more dangerous strains of the influenza virus).
Reports that it is associated with viral pneumonia, and cases of severe inflammation (which produce so-called "cytokine storms", in which inflammation sets off a positive feedback loop, sending the body's immune system into overdrive, and filling the lungs with white blood cells and other fluids). This may be associated with an unusually high death rate for 19 - 64 year olds, relative to the death rates for younger and older infected patients.
Reports that the virus is characterized by unusually high replication rates in a host.
Rising rates of hospitalizations - above 1 -- 2% of infected patients.
Reports of more than 10% of those hospitalized with Mexican swine flu dying from the disease.

Economic and Asset Allocation Implications

In recent years, there have been a large number of estimates of the amount of economic damage that could result from a serious global influenza pandemic (see, for example, "Pandemic Economics: The 1918 Influenza and its Modern Day Implications" by Thomas Garrett, or "A Potential Influenza Pandemic: Possible Macroeconomic Effects and Policy Issues" by the U.S. Congressional Budget Office). All of them agree that the impact on a normally functioning global economy could be quite serious - e.g., a reduction in global GDP of more than 2.5%. However, that is already happening, even in the absence of an influenza pandemic. The real question is whether a pandemic would make things much worse. Our guess is that while it would worsen the situation somewhat in the short term, it might actually help it in medium term. This view rests on the key assumption that a flu pandemic might move the world back towards our cooperative scenario, and off the track towards increased conflict that we seem to be on today.

In terms of asset class valuations, our previous analysis was that the primary impact of an influenza pandemic would be a sharp rise in uncertainty, and an associated increase in demand for appropriate hedges, such as short term government securities and gold. Differential demand for different currencies could be driven by perceptions that one or more areas were coping significantly better or worse with the flu outbreak. The reduced economic output associated with a flu pandemic would obviously be bad for equities, as well as commodities, assuming that the fall in demand for them would be much greater than any offsetting fall in supply. The impact on commercial property would depend on the severity of the influenza outbreak, with the more severe scenarios associated with lower valuations for commercial property, due to reduced demand. However, as noted with respect to the economic impact of pandemic flu, these negative asset allocation effects have already occurred due to the financial panic of 2008. So rather than a substantial effect, at this point we estimate that the most likely result of the Mexican swine flu (assuming it doesn't become much worse) is a damping of the (quite possibly premature) rally in global equity markets, and some further upward pressure on gold and short-term government security prices.

| May 2009 Economic Update | Grounding Risk Management in Neuroscience | May 2009 Issue: Key Points | Product and Strategy Notes: Which Asset Classes are the Best Inflation Hedges?; Gold Funds in Canada; IndexIQ New Products, Other News of Note and Pandemic Briefing | This Month's Letters to the Editor: Why Not Shorter Articles?, CUT ETF and Economic Methodology | Asset Class Valuation Update | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns |