Index Investor Corner

Swedroe: The Best Inflation Protection

December 01, 2014
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When it comes to inflation protection, what really works may come as a surprise.

A recent CNBC poll asked, “Which asset are you buying as a hedge against inflation?” The three choices offered were equities, precious metals or alternative assets.

My colleague and co-author, Kevin Grogan, found it interesting that the poll provided takers only three choices, none of which is among the best available hedges of inflation. We’ll leave “alternative assets” out of the discussion, because that selection is actually too broad a category to effectively analyze.

So let’s examine three asset classes inspired by the poll question as well as two other asset classes that provide better protection from inflation, with a special thanks to our colleague Jared Kizer for crunching the numbers:

  1. U.S. stocks (proxied by the S&P 500 Index)
  2. International developed stocks (proxied by the MSCI EAFE Index)
  3. Gold (proxied by spot gold prices from the Federal Reserve)
  4. Short-term TIPS (proxied by TIPS 0-5 Year Maturity Index)
  5. Commodities (proxied by the S&P GSCI Index)

The following table provides some statistics on how well each of these five asset classes hedge inflation. But first, the proper way to interpret the “hedge ratio” is to think of the number as the percentage allocation to each asset that would have done the best job of hedging inflation.

So, with commodities, for example, a 2 percent allocation to the S&P GSCI Index with the other 98 percent of your portfolio in cash would have done the best job of protecting against inflation over the time period. This illustrates that high-volatility asset classes can still protect a portfolio against inflation. You just need less of them to do it.

T-statistic is a measure of statistical significance, and R2 (or coefficient of determination) measures the relationship between a portfolio (or asset class, in this case) and a benchmark (inflation, in this case). The higher this number, the stronger the relationship.

September 2002 – December 2013 Hedge Ratio
(%)
t-stat R2
(%)
S&P 500 Index 0 0.4 0.1
MSCI EAFE Index 0 0.4 0.1
Gold 0 0.6 0.3
TIPS 0-5 Year Maturity Index 11 3.1 6.6
S&P GSCI Index 2 4.2 11.7

The Winning Asset Classes

The table shows that of the five asset classes we examined, only short-term TIPS and commodities did a decent job of providing protection from inflation over the selected time period. We can draw this conclusion based on the relatively high, positive t-stat associated with short-term TIPS and commodities as a hedge against inflation.

We did not include longer-term TIPS because they don’t hedge inflation in the short term, due to duration risk. However, if you hold longer-term TIPS to maturity, they hedge very well over the term of the bond.

The other asset classes do not have a statistically significant relationship with inflation, and are therefore dubious ways to protect against it.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

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