Scott Cameron, CFA
Historically much of the focus on defined contribution retirement plans has been in helping participants maximize the accumulation of assets prior to their retirement date. This is a simplistic objective based on the theory that “more is better.” A more nuanced assessment of the retirement plan objective is to accumulate sufficient assets to meet the future liability that is a participant’s retirement expenses. By framing the objective in an asset/liability framework that is most common for managing defined benefit pension plans, the investment risks that a participant faces can be explored more fully.
In particular, the greatest impact on the liability side of the ledger, other than lifestyle decisions, is inflation. Inflation is a general increase in price levels where goods in the future will cost more than those same goods cost today. If inflation is high then that increases future expenses and the associated liability for an investor. Inflation is a real risk posed to retirement investors; unfortunately it is not as explicit as market risk and therefore is frequently overlooked when constructing a portfolio.
For a long time, investors that were concerned about inflation had limited tools to manage the risk within their investment portfolio. Stocks can provide a good long-term hedge against inflation because of their high total return, but they can be negatively impacted by unexpected increases in inflation. Long-term, expected bond returns should compensate investors for the inflation risk that they face, but in a low yielding asset class inflation erodes a substantial portion of the total return, leaving little cushion for real returns if inflation exceeds expectations.
In 1997 the United States Treasury created Treasury Inflation Protected Securities (TIPS). TIPS are U.S. Treasury bonds whose principal value is adjusted based on changes in inflation (as measured by the Consumer Price Index). Every six months the principal value is adjusted based on the change in CPI. The bonds have a fixed yield and the interest payout is equal to the yield multiplied by the adjusted principal value. At maturity investors also receive the inflation-adjusted principal value.
With the advent of the TIPS market, investors were given an asset class whose returns were directly tied to inflation. TIPS funds were launched to provide exposure to the asset class and investors could then add an allocation to TIPS as a hedge within their portfolio. Many retirement plans included a TIPS fund within their investment menu for their participants who also wanted a direct inflation hedge.
While a TIPS allocation can be beneficial within a diversified portfolio, the asset class has material limitations. TIPS are more volatile than nominal Treasuries because they have a longer duration compared to similar maturity nominal Treasuries. The volatility is enhanced by investors’ tendency to flock to the asset class when concerns about inflation run high and sell out when inflation worries subside. Aside from the volatility concerns, the cost of inflation insurance through TIPS has been high. The 10-Year TIPS yield has been less than 1% since 2010 and was actually negative for an extended period of time in 2012 and 2013. Only with the general rise in interest rates in 2013 did the real yield on TIPS get back into positive territory.
Acknowledging the risks that inflation poses to investors, and the limitations that TIPS have as the sole solution, investment managers are seeking to create more sophisticated portfolios designed to help investors manage inflation risk, generate higher real returns, and provide diversity to equity and bond heavy portfolios.
These new strategies go by a variety of names but are generally referred to as “real asset” or “real return” strategies. The concept for these funds is to bundle a variety of inflation sensitive asset classes into a single solution for inflation-sensitive investors.
For retirement plan fiduciaries seeking to help their participants manage inflation risk, these portfolios may be an attractive solution, although they are not without their own complications and risks.
These real asset funds are unusual to most retirement plan fiduciaries because they are objective-based, rather than asset class defined. For the past couple of decades, as plan fiduciaries evaluated investment strategies, they were primarily choosing managers based on the asset category or Morningstar Style Box of the manager. These objective-based funds are different in that they include multiple asset classes, and are defined by the similarity of their investment objective rather than the types of securities they may own.
Real asset or real return funds typically have an investment objective that is equal to a target return above CPI, measured over a full market cycle. The objective is to provide positive real returns regardless of the corresponding performance of traditional stocks and bonds. Aside from the similarity in investment objective, these funds are a heterogeneous group. To better understand these types of funds it is necessary to understand the asset classes that are included in their portfolios.
Each investment manager selects the asset classes included in their portfolio. Generally they are looking for asset classes that have both a theoretical and empirical link to periods of high and/or rising inflation. Listed below are the most common assets classes that appear within these funds along with a definition of the asset class.
Treasury Inflation Protected Securities (TIPS)
TIPS are a type of U.S. Treasury bond whose principal value is adjusted based on changes in inflation. Every six months the principal value is adjusted based on the change in CPI. The bonds have a fixed yield, and the interest payout is equal to the yield multiplied by the adjusted principal value. At maturity investors also receive the inflation-adjusted principal value. TIPS are frequently included in these types of bond funds because of their direct link to inflation.
Commodities can broadly be grouped into five categories: precious metals, industrial metals, energy, grains, and livestock. Commodities cannot generally be “owned” by an investment manager due to the complexity that physical ownership entails. As a result, commodity exposure is gained through ownership in derivatives that are tied to the price of the commodity. Commodities are raw materials, and an increase in the price of commodities is often causal to inflation.
Natural Resource Stocks
Natural resource stocks are equity investments in companies that produce natural resources. Examples include energy, mining, material, and timber companies. These stocks are typically included because they should benefit from increases in the price of commodities that they produce.
Utilities/infrastructure investments are equity investments in companies that are utilities, or own/manage infrastructure assets. These stocks are generally highly regulated with their revenue growth tied to inflation. Because of the heavy regulation these stocks usually have a low beta to the broader equity market.
Real estate, in the form of real estate investment trusts (REITs), are typically included because the rents generated by the assets increase over time with inflation and the assets appreciate.
Gold investment typically occurs through owning derivative contracts or investing in the equity of gold mining companies. Gold is included because it is viewed as a positive store of value if currency prices decline and inflation increases.
Floating Rate Debt
Floating rate debt are bonds issued without a fixed coupon. The coupon is typically based on a spread to a public rate such as the London Interbank Offer Rate (LIBOR). Because the coupon is not fixed, these bonds are heavily correlated to short-term rate changes. This asset class is included because it will move positively if inflation pushes up nominal rates.
Currency trading is generally believed to be a zero sum game with a winner and loser on either side of a currency trade. This is not a common asset class in these types of funds. The rationale for including currency is that a depreciating currency may lead to higher inflation as the cost of goods imported are more expensive. In most cases currency strategies are not focused on positioning for a long-term trend in currency but are more focused on making short-term, specific alpha bets in the hopes of adding value.
Master Limited Partnerships (MLPs)
Master limited partnerships are publicly traded securities that are taxed as limited partnerships. They are a creation of the U.S. tax code and similar to REITs. MLPs are limited to natural resource investments, primarily energy-focused businesses such as pipeline operations and oil producers. MLPs pay higher dividends than the broad equity market and are included because these companies should increase revenue and earnings should the underlying commodities increase in price.
In many ways, except for investment objective, real assets funds are similar to target date funds. They invest based on an investment objective rather than an asset class, utilize multiple asset classes, and grant the investment manager broader authority than traditional asset class portfolios. For plan fiduciaries they present a similar set of challenges in conducting due diligence and investment monitoring.
Because of the similarities, it is appropriate to use many of the same criteria that are used in evaluating target date funds. A thorough analysis requires a review of the investment management firm’s capabilities, the asset classes chosen, and the investment management implementation.
Because the investment management firm is given broad discretion to select the appropriate asset classes, and to manage across those assets classes, it is critical to gain a deep understanding of the investment management firm’s capabilities. Factors to consider include the stability of the organization, the experience of the investment personnel, and the investment process that is utilized to manage portfolios. Plan sponsors should favor investment managers with experience managing multi-asset class portfolios, and with the breadth of capabilities to implement a diversified solution.
After evaluating the investment management firm, a plan sponsor then needs to evaluate the asset classes included in the fund. This evaluation should focus on determining how the asset allocation was developed, whether it is appropriate for the stated investment objective, and whether there are conflicts of interest that may be present because of an investment manager’s capabilities.
Lastly, understanding how the investment manager will implement their investment process and asset allocation is necessary to understand the risks inherent in the portfolio. Questions to consider are whether they are using active or passive investment strategies, proprietary or sub-advised investment mandates, and strategic versus tactical asset allocation.
Real asset or real return funds can be an attractive solution for participants seeking to diversify their equity and fixed income portfolio with inflation sensitive assets, but they pose unique challenges for plan sponsors. The biggest challenge is that the market has not reached a consensus on what these types of portfolios should look like. Each investment manager has selected their own set of asset classes they think are appropriate to meet their defined objective, so there is no consistency in a suitable benchmark across funds. Additionally, most categorization systems do not have these funds grouped together in a unique category, which makes peer group analysis of limited value.
Aside from the work necessary to select and monitor the funds, a new type of investment option requires a strategy to effectively communicate to participants both the benefits and potential risks this type of investment provides. For plan sponsors willing to tackle these challenges, these types of funds may be beneficial, but others should proceed with caution.
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