Read the article in full (5 min read)
Following the post-COVID restart, there would necessarily be an inflationary spike, from base effects alone. Central Banks’ core thesis was that this spike would be “transitory”, rather than “persistent”.
However, the combination of pent-up demand, supply chain disruptions and an energy crisis suggests that inflation could prove more persistent than transitory.
We look at the numbers and how this informs the “big picture triangle” of three key macro factors: growth, inflation and interest rates.
Finally, we outlined potential interventions in portfolio positioning from an asset allocation perspective. Nominal bonds are known to be structurally challenged in an inflationary regime, and propose real asset exposure instead. Within equities, we would propose an income/value bias.
Regiser for our 3q21 Review & Outlook: The Big Squeeze
Last week, the US Senate passed a $1.2trillion infrastructure bill that now awaits a House vote as part of the "build back better" campaign, and another part of the "bazooka" post-COVID policy stimulus.
Whilst there are plenty of infrastructure equity funds like INFR (iShares Global Infrastructure UCITS ETF) and WUTI (SPDR® MSCI World Utilities UCITS ETF) that benefit from infrastructure spend, for those not wanting to uprisk portfolio, we like GIN (SPDR® Morningstar Multi-Asset Global Infrastructure UCITS ETF) which invests in infrastructure equity and debt securities.
Infrastructure & Utilities forms a core part of our Liquid Real Assets Index, for the inflation-protective qualities (tariff formulae typically pass through inflation). The "hybrid" nature of infrastructure - with both equity and bond like components is why we place it firmly in the Alternative Assets category. Helpfully this can be accessed in a highly iquid and (relatively) low-cost format, compared to higher cost, less transparent and potentially less liquid infrastructure funds.
US inflation at highest level in 13 years running at +5.4%yy for second month, Core inflation (excl energy) +4.3%yy (Jul) from +4.5% (Jun).
With a slight moderation in core inflation, economists are calling this as the inflation "peak".
Whilst this may represent "peak inflation" year over year, overall inflation levels will remain elevated on restart and supply chain constraints
As explored in our recent article on “catch-up” rates, we believe Fed policy will remain accommodative, with interest rates "lower for longer", as it lets inflation run "hotter for longer". This is positive for risk assets that offer inflation protection
In inflationary regime we favour value-bias equities and real assets for diversification.
[3 min read, open as pdf]
The inflation theme is resonating in US earnings calls with company CEOs seeing this "temporary regime" lasting longer into 2022. In terms of prints, June CPI in the US was +5.4% and core CPI +4.5% - the highest print since November 1991.
Markets have been caught between a push-pull between inflation data and interest rate policy response. Concerns that inflation is more persistent than transitory is driving flows to “risk on” assets. Related concerns that the Fed might start tightening policy earlier and sharper has been the “risk off” trade.
Looking at inflation “catch-up” rates suggests that the Fed might let inflation run hotter for longer, pointing to a later lift off in rates from current low interest rates. This would be supportive for risk assets.
What are “catch-up” rates?
In 2020 ahead of the annual Jackson Hole conference the Fed indicated that it would take a more accommodative approach to inflation crossing the 2% target threshold.
Why is this? Part of the answer is the concept of “catch up” rates. Essentially this means that a rate above 2% temporarily is ok if it means we are getting back to a 2% long-term trend-line.
Effectively, letting inflation run hot and overshoot target in the short-term can make up for system slack/undershoots in prior years.
What are the reference points?
We don’t’ know the reference points (basis, trend-lines or catch-up period) the Fed will be using in its Policy decisions.
So to illustrate this concept of “catch up rates”, we created an example with cumulative inflation (left hand scale) and average inflation rates (right hand scale).
We took December 2005 as a base, applied a cumulative 2% target inflation path (in blue), and then plotted cumulative path based on actual inflation rate (in green, averaging (dotted green line) 1.87%p.a. to June 2020 – i.e. below target rate).
The red dashed line is the implied path back to trend-line assuming a “catch-up rate” of 2.65%p.a. (red-dotted line) that it would take for inflation to get back to the original trendline over 3 years.
The catch up rate would be higher if using a shorter time-frame, and lower if using a longer-time frame.
Looking at implied three year “catch-up” rate helpso illustrate the concept and explains why Fed might let inflation run hotter for longer, pointing to a later lift off in rates.
In inflationary regime we favour value-bias equities and real assets for diversification.
Find out more in our quarterly review and outlook.
[10 min read, open as pdf]
In this white paper, we revisit the core principles of inflation
[15 min read, open as pdf]
[3 min read, open as pdf]
Inflation is on the rise: equities provide long-term inflation protection
Inflation risk means greater focus on intrinsic value such as dividends
UK equities with value and/or income bias are attractive
Inflation is on the rise, and whilst it’s broadly accepted that equities can provide a long-term inflation hedge, which kind of equities are best positioned to provide this.
Since the financial crisis, Value investors have been jilted by a market love affair with Momentum. The switch back to Value was already being called on purely a valuation basis since late 2019. But the rekindling of inflation risk in the market is only making companies with a Value-bias and a progressive quality income stream back in the spotlight.
What is quality income?
Quality means persistency, focusing on companies that regularly pay a stable or increasing dividend, whilst mitigating dividend concentration risk.
“One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back many years.”
Indeed, research suggests that Dividends are a key anchor of Total Returns, although this differs from market to market.
Figure 1: Source: S&P Dow Jones Index Research August 2016
Figure 2: Source: JP Morgan, The Search for Income: A Global Dividend Strategy, 2012
How then to screen for companies that can deliver this type of strategy? Is it just about yield? We don’t think so.
High yield is not high quality
Screening for high dividend yield alone can lead to “value-traps” that negatively impact performance.
The poor performance is because those high-yielding companies might be poor businesses with unstable dividends.
Market cap weight or Dividend contribution weight
Traditional equity indices are market-capitalisation weighted. The resulting dividend income for an index is therefore a function of each company’s size. An alternative approach is to weight the holding in each company by its contribution to overall dividends. This way the index is focused on the biggest dividend payers, rather than the biggest companies by size. This creates a direct bias towards Yield, and an indirect bias towards Value, from a factor-exposure perspective.
Forward- or backward-looking
Active equity income managers typically look at forward-looking dividend estimates. Index-based “passive” equity income strategies often look at historic dividend yield for ranking purposes. This is sub-optimal. We believe that index strategies that focus on equity income should use forward-looking estimates, to systematically capture upswings in earnings and dividend estimates.
Equities as an inflation hedge
It’s broadly accepted that equities can provide a long-term inflation hedge. But what kind of equities are likely to perform well in an inflationary regime?
We believe there are three characteristics:
Why the Value focus in inflationary environment?
When the two major styles of investing are compared, i.e., growth and value investing, the latter style rejects the efficient market hypothesis and choses an equity with lower expectations, which is often undervalued and would profit quickly when the market adjusts itself.
During an inflationary environment, economic concepts direct that the ‘time value of money’ has a major role to play. Thus, an equity today, becomes of greater value, when compared to its worth tomorrow. Hence, value investing seems attractive in an inflationary world since the investors are less willing to pay up for future earnings and can regain their money sooner rather than later, when compared to growth investing. (Murphy, 2021)
With a global pandemic, many predicted deflation as a threat; however, with the counter-balancing forces, investors soon realized inflationary threat. (Baron, 2021). Rising inflation is good for value investing for a number of reasons. In general, equity markets are dynamic and display a stronger corelation to inflationary environment, this lays a very strong premise that higher inflation and stronger earnings are co-dependent. Financially speaking, Sectors such as energy, financial are major drivers of the major economic growth. A rise in these value stocks tends to pace up the overall economic growth, thus outperforming others. (Lebovitz,2021)
According to JP Morgan’s chief strategist, the change in investing style, this time around could be a more impactful due to several factors such as the failure of monetary and fiscal policies whilst recovering from a pandemic. (Ossinger, 2021)
Dividends, dividends, dividends: a tried and tested approach
The most fundamental explanation, by John Kingham, a value investor, states that a dividend discount model, attempts to find the true value of the stock, under any market circumstances and focuses on the dividend pay-out factors and the market expected returns.
Historically, the companies with dividend have generated higher returns when compared to companies which either have no dividend or eliminated the dividend. (Park and Chalupnik, 2021) This means that dividends hold value when it comes to the total return of the portfolio.
Moreover, with the market getting more and more inflationary, and equities getting exposed. Adding companies which can provide returns even in a low growth environment can create a sustainable portfolio.
Government bonds have not performed well with rising inflation (Baron,2021) High yielding corporate bonds offered better protection compared to government gilts since these inflations linked bonds add value in-line with RPI Inflation according to Barclays Equity Guilt Study and can protect investors from unexpected inflation, yet they are still not considered as a safe haven like government gilts. (Dillow,2021) Investment manager of Iboss Chris Rush recently told Portfolio Adviser that in order to reduce the inflationary shock the firm had already reduced its positions from treasures and gilts and incorporated strategic bonds They also plan on holding a short duration fixed income. (Cheek, 2021)
Although, it might have not been the fundamental goal, over the past several decades until 2017 dividends reported 42% of the S&P 500 Index’s total return. The global recession and now pandemic have created a lack of stability for the layer of support for future returns, however, analysts have assured there is room for recovery. (Markowicz, 2021)
Whether transitory or persistent, with inflation on the rise, there is a strong rationale for having an allocation to Value from a factor-exposure perspective. Those value-type firms that generate and pay a progressive dividend policy provides a level of inflation protection both in absolute terms and relative to bonds that is more than welcome, and potentially essential.
Henry Cobbe & Aayushi Srivastava
[ 5 min read, open as pdf]
Since an article published in 2019 pointed the historic lows in bond yields, many investment firms are starting to rethink the 60/40 portfolio. This came under even more scrutiny following the market turmoil of 2020.
While some affirm that the 60/40 will outlive us all, others argue against this notion.
We take a look at the main arguments for and against and key insights
What is a 60/40 portfolio?
A 60/40 equity/bond portfolio is a heuristic “rule of thumb” approach considered to be a proxy for the optimal allocation between equities and bonds. Conventionally equities were for growth and bonds were for ballast.
The composition of a 60/40 portfolio might vary depending on the base currency and opportunity set of the investor/manager. Defining terms is therefore key.
We summarise a range of potential definitions of terms:
Furthermore, whilst 60/40 seems simple in terms of asset weighting scheme, it is important to understand the inherent risk characteristics that this simple allocation creates.
For example, a UK Global 60/40 portfolio has 62% beta to Global Equities; equities contribute approximately 84% of total risk, and a 60/40 portfolio is approximately 98% correlated to Global Equities.
 Elston research, Bloomberg data. Risk Contribution based on Elston 60/40 GBP Index weighted average contribution to summed 1 Year Value At Risk 95% Confidence as at Dec-20. Beta Correlation to Global Equities based on 5 year correlation of Elston 60/40 GBP Index to global equity index as at Dec-20.
Why some think 60/40 will outlive us all.
The relevance of 60/40 portfolio lies in its established historic, mathematical and academic backup. Whilst past performances do not guarantee future returns, it nonetheless provides us with experience and guidance. (Martin,2019)
Research also suggests that straightforward heuristic or “rule-of-thumb” strategies work well because they aren’t likely to inspire greed or fear in investors. They become timeless. Thus, creating a ‘Mind-Gap’. (Martin,2019)
In the US, the Vanguard Balanced Index Fund (Ticker: VBINX US) which combines US Total Market Index and 40% into US Aggregate bonds, plays a major role in showcasing the success of the 60/40 portfolio that has proved popular with US retail investors (Jaffe,2019). Similarly, in the UK the popularity of Vanguard LifeStrategy 60% (Ticker VGLS60A) showcases the merits of a straightforward 60/40 equity/bond approach.
In 2020, for US investors VBINX provided greater (peak-to-trough) downside protection owing to lower beta (-19.5% vs -30.3% for US equity) and delivered total return of +16.26% volatility of 20.79%, compared to +18.37% for an ETF tracking the S&P 500 with volatility of 33.91%, both funds are net of fees. In this respect, the strategy captured 89% of market returns, with 61% of market risk.
For GBP-based investors in 2020 the 60/40 approach had lower (peak-to-trough) drawdown levels (-15%, vs -21% for global equities) owing to lower beta. The 60% equity fund delivered total return of +7.84% with volatility of 15.12%, compared to +12.15% for an ETF tracking the FTSE All World Index with volatility of 24.29%. In this respect, the strategy captured 65% of market returns, with 62% of market risk.
Why some think 60/40 has neared its end
Since its inception the 60/40 portfolio, derived 90% of the risk from stocks. In simple terms, 60% of the asset allocation of the portfolio was therefore the main driver of the portfolio. Returns (Robertson,2021). This hardly a surprise given that equities have a 84% contribution to portfolio ris, on our analysis, but the challenge made by some researchers is that if a 60/40 portfolio mainly reflects equity risk, what role does the 40% bond allocation provide, other than beta reduction?
The bond allocation is under increasing scrutiny now is because global economic growth has slowed and traditionally safer asset classes like bonds have grown in popularity making bonds susceptible to sharp and sudden selloffs. (Matthews,2019)
Strategists such as for Woodard and Harris, for Bank of America and Bob Rice for Tangent Capital have stated in their analysis that the core premise of the 60/40 portfolio has declined as equity has provided income, and bonds total return, rather than the other way round.. (Browne,2020)
Another study shows that over the past 65 years bonds can no longer effectively hedge against inflation and risk reduction through diversification can be done more adequately by exploring alternatives such as private equity, venture capital etc. (Toschi, 2021). Left unconstrained, however, this can necessarily up-risk portfolios.
With bond yields at an all-time low, nearing zero and the fact that they can no longer provide the protection in the up-and-coming markets many investors query the value provided by a bond allocation within a portfolio. (Robertson,2021)
While point of views might differ about 60/40 as an investment strategy, one aspect that is accepted is that the future of asset allocation looks very different when compared to the recent past. Rising correlations, low yields have led strategists and investors to incorporate smarter ways of risk management, explore new bond markets like China, create modified opportunities for bonds to hedge volatility through risk parity strategies, as well as using real asset exposure such as real estate and infrastructure. (Toschi, 2021)
Research conducted by The MAN Institute summarises that modifying from traditional to a more trend-following approach introduces the initial layer of active risk management. By adding an element of market timing investors further reduce the risk, when a market’s price declines.
While bonds have declined in yield, they still hold importance in asset allocation for beta reduction.
Further diversifying the portfolio with an allocation to real assets has potential to provide more yield and increased return than government bonds.
The 60/40 portfolio strategy has established itself over many decades, it has seen investors through four major wars, 14 recessions, 11 bear markets, and 113 rolling interest rate spikes.
It has proved resilience as a strategy and utility as a benchmark.
Our conclusion is that 60/40 is not dead: it is a useful multi-asset benchmark and remains a starting point for strategic asset allocation strategies.
But the detail of the bond allocation needs a rethink. Incorporating alternative assets or strategies so long as any increased risk can be constrained to ensure comparable portfolio risk characteristics.
Henry Cobbe & Aayushi Srivastava
Browne, E., 2021. The 60/40 Portfolio Is Alive and Well. [online] Pacific Investment Management Company LLC.
Available at: https://www.pimco.co.uk/en-gb/insights/blog/the-60-40-portfolio-is-alive-and-well
Jaffe, C., 2019. No sale: Don’t buy in to ‘the end’ of 60/40 investing. [online] Seattle Times.
Available at: https://www.seattletimes.com/business/no-sale-dont-buy-in-to-the-end-of-60-40-investing/
Martin, A., 2019. The 60/40 Portfolio Will Outlive Us All. [online] Advisorperspectives.com.
Matthews, C., 2021. Bank of America declares ‘the end of the 60-40’ standard portfolio. [online] MarketWatch.
Robertson, G., 2021. 60/40 in 2020 Vision | Man Institute. [online] www.man.com/maninstitute. Available at:https://www.man.com/maninstitute/60-40-in-2020-vision
Toschi, M., 2021. Why and how to re-think the 60:40 portfolio | J.P. Morgan Asset Management. [online] Am.jpmorgan.com.
Available at: https://am.jpmorgan.com/be/en/asset-management/adv/insights/market-insights/on-the-minds-of-investors/rethinking-the-60-40-portfolio/
[3 min read, open as pdf]
Inflation is on the rise
Easy central bank money, pent up demand after lockdowns and supply-chain constraints mean inflation is on the rise. Will Central Banks be able to keep the lid on inflation? The risk is that it could persistently overshoot target levels.
It matters more over time
Inflation erodes the real value of money: its “purchasing power”. If inflation was on target (2%), £100,000 in 10 year’s time would be worth only £82,035 in today’s money. But on current expectations, it could be worth a lot less than that.
Real assets can help
A bank note is only as valuable as the value printed on it. This is called its “nominal value”. Remember the days when a £5 note went a long way? When inflation rises, money loses its real value.
By contrast, real assets are things that have a real intrinsic value over time whose value is set by supply, demand and needs: like copper, timber, gold, oil, and wheat.
Real assets can also mean things that produce an regular income which goes up with inflation, like infrastructure companies (pipelines, toll roads, national grid etc) and commercial property with inflation-linked rents.
Rethinking portfolio construction
Including “real assets” into the mix can help diversify a portfolio, and protect it from inflation. Obviously there are no guarantees it will do so perfectly, but it can be done as a measured approach to help mitigate the effects of inflation. The challenge is how to do this without taking on too much risk.
Find out more about our Liquid Real Assets Index
[5min read, open as pdf]
We agree it’s time to rethink the 60/40 portfolio. It’s a useful benchmark, but a problematic strategy.
What is the 60/40 portfolio, and why does it matter?
What it represents?
Trying to find the very first mention of a 60/40 portfolio is proving a challenge, but it links back to Markowitz Modern Portfolio Theory and was for many years seen as close to the optimal allocation between [US] equities and [US] bonds. Harry Markowitz himself when considering a “heuristic” rule of thumb talked of a 50/50 portfolio. But the notional 60/40 equity/bond portfolio has been a long-standing proxy for a balanced mandate, combining higher-risk return growth assets with lower-risk-return, income generating assets.
What’s in a 60/40?
Obviously the nature of the equity and the nature of the bonds depends on the investor. US investor look at 60% US equities/40% US treasuries. Global investors might look at 60% Global Equities/40% Global Bonds. For UK investors – and our Elston 60/40 GBP Index – we look at 60% predominantly Global Equities and 40% predominantly UK bonds
Why does it matter?
In the same way as a Global Equities index is a useful benchmark for a “do-nothing” stock picker, the 60/40 portfolio is a useful benchmark for a “do-nothing” multi-asset investor.
Multi-asset investors, with all their detailed decision making around asset allocation, risk management, hedging overlays and implementation options either do better than, or worse than this straightforward “do-nothing” approach of a regularly rebalanced 60/40 portfolio.
Indeed – its simplicity is part of its appeal that enables investors to access a simple multi-asset strategy at low cost.
The problem with Bonds in a 60/40 framework
In October 2019, Bank of America Merrill Lynch published a research paper “The End of 60/40” which argues that “the relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies”.
This has prompted a flurry of opinions on whether or not 60/40 is still a valid strategy
The key challenges with a 60/40 portfolio approach is more on the bond side:
So is 60/40 really dead?
In short, as a benchmark no. As a strategy – we would argue that for serious investors, it never was one.
We therefore think it’s important to distinguish between 60/40 as an investment strategy and 60/40 as a benchmark.
We think that a vanilla 60/40 equity/bond portfolio remains useful as a benchmark to represent the “do nothing” multi-asset approach.
However, we would concur that a vanilla 60/40 equity/bond portfolio, as a strategy offered by some low cost providers does – at this time – face the significant challenges identified in the 2019 report, that have been vindicated in 2020 and 2021.
For example, during the peak of the COVID market crisis in March 2020, correlations between equities and bonds spiked upwards meaning there was “no place to hide”. The growing inflation risk has put additional pressure on nominal bonds. Real yields are negative. Interest rates won’t go lower.
But outside of some low-cost retail products, very few portfolio managers, would offer a vanilla equity/bond portfolio as a client strategy. The inclusion of alternatives have always had an important role to play as diversifiers.
Rethinking the 40%: What are the alternatives?
When it comes to rethinking the 60/40 portfolio, investors will have a certain level of risk budget. So if that risk budget is to be maintained, there is little change to the “60% equity” part of a 60/40 portfolio.
What about the 40%?
We see opportunity for rethinking the 40% bond allocation by:
We nonetheless think it is important to:
1. Rethinking the bond portfolio
Whilst more extreme advocates of the death of 60/40 would push for removing bonds entirely, we would not concur.
Bonds have a role to play for portfolio resilience in terms of their portfolio function (liquidity, volatility dampener), so would instead focus on a more nuanced approach between yield & duration.
We would concur that long-dated nominal bonds look problematic, so would suggest a more “barbell” approach between shorter-dated bonds (as volatility dampener), and targeted, diversified bond exposures: emerging markets, high yield, inflation-linked (for diversification and real yield pick-up).
2. Incorporating sensible alternative assets
Allocating a portfolio of the bond portfolio to alternatives makes sense, but we also need to consider what kind of alternatives.
Whilst some managers are making the case for hedge funds or private markets as an alternative to bonds, we think there are sensible cost-efficient and liquid alternatives that can be considered for inclusion that either have bond-like characteristics (regular stable income streams), or provide inflation protection (real assets).
For regular diversified income and inflation protection, we would consider: asset-backed securities, infrastructure, utilities and property. The challenge, however, is how to incorporate these asset classes without materially up-risking the overall portfolio.
For inflation protection, we would consider real assets: property, diversified, commodities, gold and inflation-protected bonds.
Properly incorporated these can fulfil a portfolio function that bonds traditionally provided (liquidity, income, ballast and diversification).
3. Consider risk-based diversification as an alternative strategy
One of the key reasons for including bonds in a multi-asset portfolio is for diversification purposes from equities on the basis that one zigs when the other zags.
In the short-term, and particularly at times of market stress, correlations between asset classes can increase, this reduces the diversification effect if bonds zag when equities zag.
We would argue risk-based diversification strategies have a role to play to here, on the basis that rather than relying on long-run theoretical correlation, they systematically focus on short-run actual correlation between asset classes and adapt their asset allocation accordingly.
Traditional portfolios means choosing asset weights which then drive portfolio risk and correlation metrics.
Risk-based diversification strategies do this in reverse: they use short-run portfolio risk and correlation metrics to drive asset weights.
If the ambition is to diversify and decorrelate, using a strategy that has this as its objective makes more sense.
So 60/40 is not dead. It will remain a useful benchmark for mult-asset investors.
As an investment strategy, vanilla 60/40 equity/bond products will continue to attract assets for their inherent simplicity. But we do believe a careful rethink of the “40” is required.
[5 min read, open as pdf]
Commodity indices, and the ETPs that track them provide a convenient way of accessing a broad commodity basket exposure with a single trade.
What’s inside the basket?
Commodity indices represent baskets of commodities constructed using futures prices. The Bloomberg Commodity Index which was launched in 1998 as the Dow Jones-AIG Commodity Index has a weighting scheme is based on target weights for each commodity exposure.
These weights are subject to the index methodology rules that incorporate both liquidity (relative amount of trading activity of a particular commodity) and production data (actual production data in USD terms of a particular commodity) to reflect economic significance.
The index subdivides commodities into “Groups”, such as: Energy (WTI Crude Oil, Natural Gas etc), Grains (Corn, Soybeans etc), Industrial Metals (Copper, Aluminium etc), Precious Metals (Gold, Silver), Softs (Sugar, Coffee, Cotton) and Livestock (Live Cattle, Lean Hogs).
The index rules include diversification requirements such that no commodity group constitutes more than 33% weight in the index; no single commodity (together with its derivatives) may constitute over 25% weight); and no single commodity may constitute over 15% weight.
The target weights for 2021 at Group and Commodity level is presented below:
Owing to changes in production and or liquidity, annual target weights can vary. For example the material change in weight in the 2021 target weights vs the 2020 target weights was a +1.6ppt increase in Precious Metals (to 19.0%) and a -1.9pp decrease in Industrial Metals to 15.6%.
Traditional vs “Smart” weighting schemes
One of the drawbacks of the traditional production- and liquidity-based weighting scheme is that they are constructed with short-dated futures contracts. This creates a risk when futures contracts are rolled because for commodities where the forward curve is upward sloping (“contango”), the futures price of a commodity is higher than the spot price. Each time a futures contract is rolled, investors are forced to “buy high and sell low”. This is known as “negative roll yield”.
A “smart” weighting scheme looks at the commodity basket from a constant maturity perspective, rather than focusing solely on short-dated futures contracts. This approach aims to mitigate the impact of negative roll yield as well as potential for reduced volatility, relative to traditional indices.
This Constant Maturity Commodity Index methodology was pioneered by UBS in 2007 and underpins the UBS Bloomberg BCOM Constant Maturity Commodity Index and products that track it.
Illustration of futures rolling for markets in contango
An Equal Weighted approach
Whilst the traditional index construction considers economic significance in terms of production and liquidity, investors may seek alternative forms of diversified commodities exposure, such as Equal Weighted approach.
There are two ways of achieving this, equal weighting each commodity, or equal weighting each commodity group.
The Refinitiv Equal Weight Commodity Index equally weights each if 17 individual commodity components, such that each commodity has a 5.88% (1/17th) weight in the index. This results in an 18% allocation to the Energy Group, 47% allocation to the Agriculture group, 12% allocation to the Livestock group and 23% allocation to Precious & Industrial Metals.
An alternative approach is to equally weight each commodity group. This is the approach we take in the Elston Equal Weight Commodity Portfolio, which has a 25% allocation to Energy, a 25% allocation to Precious Metals, a 25% Allocation to Industrial Metals and a 25% Allocation to Agricultural commodities. This is on the basis that commodities components within each group will behave more similarly than commodity components across groups.
These two contrasting approaches are summarised below:
In 2020, the Equal Weight component strategy performed best +6.28%. The Constant Maturity strategy delivered +0.69%. The Equal Weight Group strategy was flat at -0.05% and the traditional index was -5.88%, all expressed in GBP terms.
Informed product selection
This summarises four different ways of accessing a diversified commodity exposure: traditional weight, constant maturity weighting, equal component weighting and equal group weighting. Understanding the respective strengths and weaknesses of each approach is an important factor for product selection.
[3 min read, open as pdf]
Focus on inflation
In our recent Focus on Inflation webinar we cited the study by Briere & Signori (2011) looking at the long run correlations between asset returns and inflation over time.
We highlighted the “layered” effect of different inflation protection strategies (1973-1990) with cash (assuming interest rate rises), and commodities providing best near-term protection, inflation linked bonds and real estate providing medium-term protection, and equities providing long-term protections. Nominal bonds were impacted most negatively by inflation.
Source: Briere & Signori (2011), BIS Research Papers
Given the growing fears of inflation breaking out, we plotted the YTD returns of those “inflation-hedge” asset classes, in GBP terms for UK investors, with reference to the US and UK 5 Year Breakeven Inflation Rates (BEIR).
Figure 2: Inflation-hedge asset class performance (GBP, YTD) vs US & UK 5Y BEIR
Source: Elston research, Bloomberg data, as at 5th March 2021
Winners and Losers so far
We looked at the YTD performance in GBP of the following broad “inflation hedge” asset classes, each represented by a selected ETF: Gilts, Inflation Linked Gilts, Commodities, Gold, Industrial Metals, Global Property, Multi-Asset Infrastructure and Equity Income.
Looking at price performance year to date in GBP terms:
So Inflation-Linked Gilts don’t provide inflation protection?
Not in the short run, no.
UK inflation linked gilts have an effective duration of 22 years, so are highly interest rate sensitive. Fears that inflation pick up could lead to a rise in interest rates therefore reduces the capital value of those bond (offset by greater level of income payments, if held to maturity).
So whilst they provide medium- to long-term inflation protection, they are poor protection against a near-term inflation shock.
In conclusion, we observe:
[2 min read, open as pdf]
A Factor-based approach to investing
Factor-based investing means choosing securities for an inclusion in an index based on what characteristics or factors drive their risk-return behaviour, rather than a particular geography or sector.
Just like food can be categorised simply by ingredients, it can also be analysed more scientifically by nutrients. Factors are like the nutrients in an investment portfolio.
What are the main factors?
There is a realm of academic and empirical study behind the key investment factors, but they can be summarised as follows
The different factors can be summarised as follows:
Which has been the strongest performing factor?
Momentum has been the best performing factor over the last 5 years. Value has been the worst performing factor.
Fig.1. World equity factor performance
Source: Elston research, Bloomberg data
A crowded trade?
Data points to Momentum being a “crowded trade”, because of the number of people oerweighting stocks with momentum characteristics. This level of crowdedness can be an indicator of potential drawdowns to come.
Fig.2. Momentum Factor is looking increasingly crowded
Source: MSCI Factor Crowding Model
The best time to buy into a Momentum strategy has been when it is uncrowded – like in 2001 and 2009, which is also true of markets more generally. MSCI’s research suggests that with crowding scores greater than 1 were historically more likely to experience significant drawdowns in performance over subsequent months than factors with lower crowding scores.
Fig.3. Factors with higher crowding score can be an indicator of greater potential drawdowns, relative to less crowded factors
Source: MSCI Factor Crowding Model
Rotation to Value
The value-based approach to investing has delivered lack lustre performance in recent times, hence strategists’ calls that there may be a potential “rotation” into Value-oriented strategies in coming months as the post-COVID world normalises. But can factors be timed?
Marketing timing, factor timing?
Market timing is notoriously difficult. Factor timing is no different. To get round this, a lot of fund providers have offered multi-factor strategies, which allocate to factors either statically or dynamically. Whilst convenient as a catch-all solution, unless factor exposures are dynamically and actively managed, the exposure to all factors in aggregate will be similar to overall market exposure. This has led to a loss of confidence and conviction in statically weighted multi-factor funds.
Factors help break down and isolate the core drivers of risk and return.
For more on Factor investing, see