Inflation-proofing your portfolio

In 2011 South African equities delivered below-inflation returns. Local equities also underperformed inflation in 2002 and 2008.

None of this unusual.

Investors need to understand that over the short-term the local inflation cycle can peak in parallel with falling equity markets causing occasional below-inflation returns on equities.

Viewed over the longer term, since 1962 for example, the local equity market delivered real returns of 12% per annum.

As such “investors should focus on long-term investment objectives and not attempt to alter investment strategies based on shorter-term market outcomes, which often have undesired consequences” says Brink Vermaak, Head: Market, Economic and Quantitative Research, Investment Solutions

Yet despite equities having historically delivered the highest inflation-beating returns in the long term, it does not mean investors should invest their entire portfolio in this asset class.

Instead, diversified investment portfolios with real-return targets have been designed to deliver inflation-beating returns over the long term at an appropriate risk tolerance level. For such portfolios, “research results show that diversification in offshore assets is crucial to achieving inflation-beating returns” adds Vermaak.

This is based on the premise that since the rand exchange rate is an important driver of inflation, a natural hedge against rising inflation is to invest offshore. This strategy protects investors against potential rand depreciation and hence rising inflation.

The below table shows rand returns for various asset classes accessible to local investors against inflation in 2011. Specifically, it demonstrates “how the rand’s 22% depreciation against the dollar in 2011 boosted the return of global bonds and equities when expressed in rand terms” observes Vermaak.

Asset Class Returns for 2011

Source: I-Net Bridge

While global bonds as an asset class remain extremely expensive, global equities offer attractive value relative to their South African counterparts, currently regarded as fully valued.

Also, inflation-linked bonds provide an excellent base of real returns into any portfolio as they pay a yield above inflation on income and capital, assuming no de-rating in the asset class.

Similarly, listed property, assuming no major change in interest rates, provides protection against inflation as rentals rarely escalate by less than inflation - introducing a natural hedge against inflation from an income perspective.

Finally, portfolios with real-return targets need to have a decent portion invested in rand-hedge stocks, “typically companies that derive some portion of their earnings outside South Africa” explains Vermaak.

It is strongly recommended that investors aiming at inflation-beating returns ensure their investment strategies incorporate some of these elements.