Scientific Beta: How to protect your equity portfolio against rising inflation

18 januari 2022

By Mikheil Esakia and Felix Goltz, respectively Quantitative Research Analyst and Research Director at Scientific Beta

Inflation fears among investors have been growing on the back of unprecedented fiscal stimulus and swift economic recovery. Alleviating these fears by using hedging instruments, such as inflation-protected bonds, comes with high opportunity costs in the form of low expected returns.

As an alternative, many investors turn to their equity portfolio to seek protection against inflation surprises. Equities are a natural candidate to provide protection and also offer a positive long-term risk premium. The objective for such investors is to find an equity portfolio that offers the most efficient inflation protection.

Investment practice does not have a convincing solution for this objective. Investment managers mainly rely on off-the-shelf building blocks, such as sectors or style factors, to manage exposure to inflation. However, such building blocks have never been designed to efficiently target inflation risks. Moreover, strategies that target inflation are often discretionary. The lack of transparency and replicability of such approaches makes them hard to evaluate.

How does our approach work?

Our research sets out to tackle the challenge of targeting inflation exposures in a completely systematic and replicable way. In contrast with sector or style allocation strategies, we propose to build dedicated portfolios from stock-level information to achieve inflation protection. By exploiting differences in firm-level exposures to inflation, instead of relying on pre-existing equity portfolios such as sector indices, we aim to provide more reliable inflation protection.

While it is natural to expect firms to react differently to inflation shocks, measuring such differences reliably is a major challenge. We develop a robust measurement approach to identify differences in inflation exposure. First, we exploit market-based information on inflation expectations – as opposed to using backward-looking and low-frequency indicators of realised inflation. Second, our measurement approach applies robust statistical methods to returns data, complemented with automated analysis of risk disclosure texts in firms’ annual reports. The approach leads to highly reliable exposures out of sample.

We construct dedicated equity indices using this information on stock-level inflation exposures. Additional index rules allow inflation exposures to be targeted efficiently with moderate deviation from the market index, both in terms of tracking error and investability. The resulting index, the Scientific Beta US Inflation+ index, has provided strong protection against inflation with annualised outperformance of around 8% during times of increasing inflation expectations. Importantly, the index has also shown unconditional performance like a market index, with tracking error below 3% and a high level of investability.

The benefits of our approach

Our approach captures inflation exposures more reliably than using off-the-shelf building blocks, such as sector or factor indices. Allocating across sectors or factors leads to weaker exposures than our dedicated portfolios and sometimes even leads to exposures that are inconsistent with the objective. This is because sectors or factors are not designed to discriminate between assets by inflation exposure, while our approach fully exploits the differences of exposures across firms.

In addition to capturing inflation exposure more reliably, dedicated equity indices offer other investment advantages over standard building blocks. For example, we find that small-cap indices and financial sector indices can indeed provide protection against inflation. However, this protection comes at the cost of substantially greater deviations from the cap-weighted market index and reduced diversification. Therefore, such strategies are ill-suited as an alternative to the market cap-weighted index.

Equity indices targeting positive inflation exposure are a good substitute for a cap-weighted equity market index for investors who are concerned with inflation risk. Such indices are fully systematic and do not rely on common beliefs or the discretionary choices of an asset manager. While investors may use traditional tools (inflation-linked bonds or inflation swaps) to hedge precisely against inflation, dedicated equity indices targeting inflation protection are suitable ingredients for the performance-seeking portfolio, as they can provide long-term performance together with inflation-protection benefits.