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Business Officer Magazine
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Think Timber

Inflation hedges such as timber, real estate, and TIPS can produce a big bang for your buck—if you invest wisely and understand the risks.

By Jay A. Yoder

“Inflation Jitters Leave Stocks Flat”; “Ghosts of Inflation Past”; “How to Plan for Inflation”; “Inflation Data to Set Tone This Week”

As these recent articles from The Wall Street Journal attest, inflation concerns have returned to the headlines after being absent for many years. What’s the smart, forward-looking investor to do? As Larry Siegel, director of policy research at the Ford Foundation, wrote, “For almost all investors, the prudent thing is to hedge against inflation.”

Business officers must be cognizant of the serious threat that inflation poses and take actions that protect against—or at least alleviate—inflation’s pernicious effect on endowment value. Despite its dormancy for 15 years prior to 2005, inflation is one of the greatest potential threats to any long-term pool of funds. Many endowments and pension plans lost an incredible 40 percent or more of their purchasing power from 1973 to 1982 because of inflation. According to figures compiled by the University of Notre Dame investment office, there were 23 three-year periods in the 20th century when real (inflation-adjusted) U.S. equity returns were negative. In 14 of those instances, high inflation was the major cause of the sustained period of negative real equity returns.

Some assets, however, are positively correlated to inflation: real estate, timber, energy, gold, Treasury Inflation-Protected Securities (TIPS), and commodities. These investments are generally referred to as inflation hedges or real assets. By definition, inflation hedges have historically provided attractive returns during inflationary times when traditional stocks and bonds have performed poorly.

Acting as an insurance policy, an allocation to real assets provides a measure of protection against unexpected inflation and sustained periods of general price increases. Most types of insurance cost money; the great thing about adding inflation hedges to an endowment is that doing so “costs” the investor nothing. There’s no need for colleges or universities to sacrifice anything to add this inflation insurance. In fact, real assets provide additional benefits to your portfolio beyond protection against inflation.

Inflation hedges do pose risks, however, including illiquidity, vintage year risk, and poor manager selection. Careful review of hedges is required. To make the most of a real assets allocation, consider recommendations about several hedges that can benefit your institution’s portfolio.

Deciding How to Invest

During non-inflationary times, most inflation hedges will produce equity-like returns, or 8–15 percent net of fees (and the fees can be substantial). Timber, for example, has earned an annualized return of about 13 percent during the past 30 years. Similarly, energy, real estate, and commodities have earned low double-digit returns. TIPS are the exception: Although they have performed quite nicely over the past several years, TIPS cannot reasonably be expected to produce equity-like returns during normal times. The low double-digit returns expected from inflation hedges mean that an allocation to this asset class is likely to enhance the return of your portfolio, especially if drawn partially from your fixed income allocation.

If higher returns and a measure of inflation protection aren’t sufficiently attractive, the inclusion of real assets in your portfolio provides a third benefit: valuable diversification and volatility reduction for the overall endowment. Unlike most traditional asset classes and equity-oriented hedge funds, inflation hedges usually have low or negative correlation with U.S. stock and bond market returns. Adding an allocation to inflation hedges will reduce the volatility of returns from your portfolio. Long-term historical returns and asset allocation tools will demonstrate that the risk/return characteristics of an endowment with, say, a 10 percent allocation to real assets are superior to those of an endowment without real assets. These factors prompted me to introduce and implement the new asset class of “inflation hedges” when I worked at Vassar College in the late 1990s.

Small Allocation, Big Difference

Several years ago my investment committee at Smith College asked whether a small allocation to inflation hedges would really make a difference. In response, I directed a study to determine the impact that a 10 percent allocation to inflation hedges would have had over the previous three decades, assuming a beginning market value of $1 billion and using actual historical returns. It came as no surprise that a portfolio with inflation hedges would have had higher returns and lower volatility than one without. The magnitude of the differences, however, was eye-popping. The portfolio with inflation hedges

  • would have had an ending value $482 million greater than the portfolio without inflation hedges, and
  • would have generated $300 million in additional distributions during this period (assuming annual distributions of 5 percent).

Main Inflation Hedges

Over several decades, the impact of a 10 percent allocation can be enormous. I recommend that a real assets allocation include exposure to most of the main inflation hedges: timber, energy, real estate, TIPS, and commodities.

Timber. Timberland supplies the basic raw material for a critical global industry: forest products. Timber can be managed economically as a renewable crop on hundreds of millions of acres in the United States. Given the forces supporting the conservation of forests in their natural state on many public and some private lands in the United States and other nations, there is increasing pressure on the remaining privately owned forests to supply the needed timber output. This represents an excellent opportunity for patient, long-term investors.

The biological growth of trees yields consistent, predictable growth that is the major component of timberland returns. In addition to volume-boosting biological growth, trees also becomes more valuable per board foot as they grow larger (referred to as in-growth) because they can be used to create higher-value products.

Tips for Getting Started

Ready to make allocations to inflation hedges? Follow these general guidelines:

  • Consider exposure to the main inflation hedges: timber, energy, real estate, TIPS, and commodities.
  • Understand that the potential benefits of adding real assets to your portfolio include higher returns, inflation protection, and volatility reduction for the overall endowment.
  • Be aware of the risks associated with alternative investments—illiquidity, vintage year risk, and poor manager selection—and the potential consequences.
  • Reduce risk by educating yourself, performing due diligence, and using a fund-of-funds manager.

Timber managers are generally categorized by the types of trees they specialize in (softwoods or hardwoods) and the geographical focus of their efforts. The value of all timber is affected to some extent by the same macroeconomic factors (primarily U.S. and world economic growth). At the same time, various tree species have their own advantages and disadvantages, and different regions are subject to specific local factors including state environmental regulations and economic strength. In building a timber allocation, therefore, an investor should obtain both wood type and geographical diversification to reduce risk.

Energy. Oil and gas prices are affected by many factors, including world economic growth, politics, and events in the Middle East. In the past 30 years, however, energy prices have shown a solid correlation to inflation. Energy prices and returns from private energy-related investments have low or even negative correlation with U.S. stock and bond market returns. This is not true, however, for public energy stocks, which are highly correlated to U.S. equity market returns, and therefore less effective as an inflation hedge.

There are three major approaches to investing in the energy sector: 

  • Exploration and drilling. Investing in exploration and drilling for oil or natural gas is a highly speculative activity with an extremely high risk/reward profile. This strategy is unlikely to serve as an inflation hedge since returns are driven by the success or failure of drilled wells.
  • Acquisition and production. This approach makes direct investments in producing oil and gas properties. Funds acquire, develop, and operate these mature properties on investors’ behalf. Value is added by reducing operating costs or boosting production through operational efficiencies. Thus, the emphasis is on the control and management of physical operations. A related strategy is acquiring royalty interests (a share of the gross revenue stream) in producing properties.
  • Private equity focus. This strategy involves making significant—usually controlling—equity investments in private companies operating in a range of energy industry sectors including exploration and production, technology, pipelines, oil field services, and equipment manufacturing. Funds typically look for companies with strong management, favorable growth prospects, and the potential for follow-on acquisitions. Funds use their own capital, contacts, and operational expertise to boost the growth and profitability of these companies. 

Exploration and drilling investments are not appropriate for most colleges and universities because of their speculative nature. However, it would certainly be prudent to pursue opportunities in both the acquisition and production and private equity categories. The former offers greater inflation hedging potential than the private equity approach because returns are more closely related to energy prices. Returns from the acquisition and production strategy, however, are generally more volatile. The private equity approach offers an opportunity for adding value by building better companies, but it is probably less of a direct inflation hedge than the acquisition/production approach. Diversification by strategy in a volatile area such as energy is desirable and valuable as a risk-reduction measure.

Real estate. Institutional real estate investing typically encompasses office buildings, apartments, industrial warehouses, hotels, shopping centers, and malls. Traditionally, real estate has been viewed as a decent, though not perfect, hedge against inflation. As prices rise, rents and property values also rise. Private real estate has been negatively correlated with other major asset classes. Public REITs, on the other hand, are more highly correlated with stock market returns. Because stocks are often hurt by inflationary pressures, private real estate is the better inflation hedge. Since more aggressive (opportunistic) real estate strategies use greater leverage, they may offer less inflation protection due to their significant interest rate risk. 

TIPS. Treasury Inflation-Protected Securities are U.S. government-guaranteed bonds that protect investors from rising inflation. TIPS are structured with a fixed coupon rate that is set at the time of original issuance. This represents the real rate of return required by investors at that time. The bond’s principal is then adjusted upward based on changes to the Consumer Price Index. Because a fixed coupon rate is applied to the growing principal balance, interest payments also rise with inflation. In effect, TIPS guarantee investors a real rate of return when held to maturity rather than a nominal one. TIPS are the most direct and purest inflation hedge. Unfortunately, they also have the lowest expected return. The higher your benchmark for real assets, the less you can rely on TIPS to meet your objectives.

Commodities. Although their ability to hedge inflation and improve a portfolio’s risk/return profile has been pretty well demonstrated, investors have not widely embraced commodities (including hard assets such as industrial metals, precious metals, oil, natural gas, and agricultural products). This is likely because of significant volatility and investors’ lack of understanding about commodities. Another difficulty has been finding an appropriate vehicle for investment. Indexes such as the Goldman Sachs Commodity Index and the S&P Commodity Index have been created to provide a mechanism for investing in a broad range of commodities. Despite their associated difficulties, commodities deserve a place within a well-diversified allocation to inflation hedges.

Knowing the Risks…

Inflation hedges have common risk factors that are associated with many alternative investments. Low correlation between inflation hedges and traditional investments is the secret to earning higher returns at reduced risk. When the U.S. stock market generates huge returns as it did in 2003, however, the best bets are investments that are highly correlated with the U.S. stock market instead of inflation hedges with their low or negative correlations.

Illiquidity is a risk for timber, real estate, and energy investors. Funds investing in these areas have an expected life of 8–12 years—meaning at least a portion of investors’ money is inaccessible for a long time.

Vintage year risk is another concern that affects all private equity investments, including timber, energy, and real estate. This is the risk that substantial investments will be made at or near the peak of a market cycle. For example, a timber fund that invests much of its capital during a year when timber prices are at a cyclical high is unlikely to produce good returns, no matter how well-managed the fund. Poor vintage years can only be known in hindsight, so you must make a long-term commitment to these assets and invest regularly across time.

Poor manager selection is another major risk. Wide disparity exists between the best and worst managers of alternative investments, including real assets.

All of these risk factors can culminate in overall career or reputation risk. Your career or reputation (or the reputation of the institution) could be impaired if you do something different from what everyone else is doing—with little or no success. Of course, risk is what scares away many investors and enables others to earn attractive returns.

…And How to Mitigate Them

There are several ways to reduce the common risks associated with inflation hedges.  

  • Ensure that all decisions are driven by sound policy rationales—not by recent returns. None of us can control the markets. We can, however, ensure that sound investment policies exist and that they are implemented wisely and efficiently.
  • Thoroughly educate yourself and your investment committee about real estate, TIPS, timber, energy, and commodities.
  • Perform strong due diligence. Evaluating prospective managers requires attention to the four P’s: people, philosophy, process, and performance. 
  • Make a long-term commitment to inflation hedges to reduce the illiquidity and vintage year risks.
  • Use a well-managed fund-of-funds to mitigate all risks: manager risk by using multiple managers; due diligence risk (having another level of research and oversight); vintage year risk; and career risk. With the latter, the institution may be able to deflect much of the blame—and therefore much of the reputation risk—to the fund-of-funds manager if things go sour.  

Benchmark to Reap Benefits

Resources
  • Endowment Management: A Practical Guide, by Jay Yoder (Association of Governing Boards of Universities and Colleges, 2004)
  • “Who Calls the Shots?” by Mike McNamee, October 2005 Business Officer

Investment results for a real assets or inflation hedges asset class should be measured against reported inflation to assess whether the objective is being met. A benchmark consisting of a premium over the Consumer Price Index is appropriate and demands that required returns rise with increases in inflation. A benchmark of CPI + 5 percent would require the asset class to earn a return of 8 percent, which is between those expected from fixed income and equities, during periods of average inflation (3 percent historically). A CPI + 5 percent benchmark also matches nicely with most endowments’ financial objective of earning their spending rate plus inflation. Individual institutions can dial up or down the premium over CPI, depending on how much risk you are willing to take and what percentage of the asset class will be allocated to TIPS.

Many institutional investors now have significant policy allocations to inflation hedges or real assets. Harvard and Yale, for example, have allocations to real assets of more than 20 percent. Isn’t it time you do the same and reap the benefits of higher returns, reduced risk, and a measure of protection against higher inflation?

JAY A. YODER is chief investment officer of the Tuckerbrook Real Assets Fund, Boston.