Trend-following and inflation protection

Can CTAs hedge inflation risk?

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Inflation is back on investors’ minds, with most commodity prices, longer-term interest rates and expected inflation rates having risen sharply in the past six months. Increasing concerns about a rise in inflation and the damage it could cause raise the question of how to best hedge against such scenario. In this note, we perform an empirical and comparative analysis of the inflation hedging characteristics of traditional asset classes such as equities, bonds and commodities, a risk parity allocation and a generic trend-following program. To do so, we use more than 50 years of price data and a simple but rigorous framework. To assess a portfolio’s inflation hedging characteristics, we consider three complementary factors:

  • the Portfolio's sensitivity (or ‘beta’) to quarterly changes in inflation,
  • the realized conditional risk-adjusted returns in different inflation regimes, and
  • long-term risk premia or cost effectiveness related to hedging inflation risks

We show that the effectiveness and reliability of hedging inflation varies greatly amongst asset classes. Equities and bonds, for instance, have failed historically as individual asset classes to protect against the risk of an inflationary market environment.

Traditional equity/bond and risk parity portfolios are therefore likely at risk of significant losses in the event of an unexpected inflation shock. This is confirmed by the striking observation that, since 1962, high inflation environments have been systematically accompanied with a positive equity/bond correlation structure. Conversely, and maybe less surprisingly, we show that of all major asset classes, commodities have historically provided the strongest protection against inflation risk. At the same time, we highlight that such inflation protection also comes at a significant cost, i.e. with lower long-term risk-adjusted returns.

Unlike static single- or multi-asset class portfolios, a trend-follower’s dynamic and diversified risk allocation process allows to opportunistically capture inflation-driven market price dynamics across a wide range of asset classes. These intrinsically adaptive characteristics lead to a highly robust inflation sensitivity profile and attractive risk- and inflation-adjusted returns irrespective of low or high, declining or rising inflation. We conclude that, among all options analyzed, diversified trend-following offers smart diversification and cost-effective protection against rising inflation, without sacrificing expected long-term returns.

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Quantica Capital
May 25, 2021