Many portfolios are poorly positioned for rising inflation and increasing growth, believes David Jane, as such an environment may herald a major allocation shift to real assets
Back in 2008, before the financial crisis and accompanying bear market, Warren Buffett bet $1m (£800,000) a ‘plain vanilla' equity index strategy would beat a hand-picked selection of hedge funds. Obviously 2008 was not a pleasant year for the equity index strategy but, despite that huge setback, the S&P 500 index, for example, has beaten not just the average strategy but each of the five hedge fund of funds selected by his opponent.
We are by no means advocates of indexation and, while this bet has in some places been seen as an active versus passive debate, we view it more as the power of being exposed to real assets versus the allure of alternatives, which seek to remove market risk and replace it with a return from skill.
The attraction of avoiding market volatility is great and, for that reason - and despite on average producing extremely low returns - a huge amount of money has found its way into such strategies over the past decades. This now accounts for a material amount of globally invested assets, particularly for long-term institutional and ultra-high net worth investors. The estimated total amount invested in hedge funds is $3tn, which compares with $35tn for global equities.
The other asset class that has been a beneficiary of a long-term shift away from equity is fixed income. It is understandable that a huge amount of money has been drawn into fixed income during a period of low inflation and falling bond yields, especially given bonds have outperformed equity in the last 10 years with considerably less volatility.
Positive real returns from fixed income in the future are implausible from current levels, given that real yields are negative in most places. As inflation continues to rise - it is now 2.3% in the UK - a yield of 2.4% on a portfolio of UK corporate bonds starts to lose its allure.
Time to take stock
Following what has been a very strong run for equities, investors need to take stock and consider what may happen next. Clearly, a number of surveys suggest variously excessive bullishness, high valuations and so on. No doubt there will be a correction of some magnitude - after all, real assets are volatile.
It seems evident to us, however, that if you believe the era of falling inflation is in the past and the market's expectation of 3%-plus inflation is correct, many portfolios are very poorly positioned for the coming years. A large number of ‘big money' investors have structurally reduced their exposure to real assets in favour of alternatives and bonds over the past decades and neither of these are likely to perform well in the coming environment.
While there is always the risk of a correction in the near term, if we are to believe the market is right regarding inflation, we may be at the start of a major asset allocation shift in favour of real assets such as equity, property and commodities, versus fixed income and alternatives. If this is the case, the sheer weight of money should drive equity markets higher, as the weight of money has seen bond markets move to seemingly irrational levels.
David Jane is manager of Miton's multi-asset fund range
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