Given the dominance of inflation in today's capital markets discussion, it should be no surprise to anyone watching this video that one of the most common questions I get is, “How do I inflation-protect my portfolio?” And that's what we're going to focus on today: what to think about when you're thinking about inflation protection.
So let's start with the obvious, how effective of a hedge is it? We've done research over time on real assets, for example, and there are three lenses through which we judge the effectiveness of those hedges. The first of which is reliability, how consistent is this investment as an inflation fighter over time? Secondly, magnitude. We call it the “inflation beta.” How much does this investment move when inflation appears? And then the third, and this is really important, is cost-effectiveness. So, for example, in equities, if I was trying to look for a segment of the equity market with an inflation-protection history, I could find it. I was just talking about real assets. How about the equities of real asset producers or value, which classically tends to do reasonably well in inflationary environments?
However, we believe that a lot of the heavy lifting of inflation protection comes more at a corporate level, in the ability of a company to navigate an inflationary environment, to pass through price increases, and that allows us to not become heavily concentrated by seeking out sectors and instead be diversified and also maintain a broad exposure to market returns. Again, in pursuit of inflation protection with broad market exposure.
The same thing as it relates to fixed income. Implicitly speaking, I can just add credit if I want to try to add some level of buffer against inflation. Why? Because one of the best ways to beat rising yields for any reason is to out-yield it. It provides me with both a yield buffer and, if that inflation is coming in a reasonably strong economic environment, I can also have capital gains from spread compression inside of credit, both of them matter. But there is another side, which is explicit protection inside of the fixed-income world. And many of you know all about these, folks. Outside of the United States, these inflation link securities are often referred to as “linkers,” and inside of the United States, they're in the MIPS family. MIPS, municipal inflation-protected securities, and on the taxable side, Treasury Inflation-Protected Securities or TIPS. If you take a nominal or a garden variety treasury, and you think about the coupon, it's basically broken down into two things. One is the amount of compensation you get from the government for lending them money. The real yield. The second is compensation for expected inflation over the life of the bond so that your initial investment maintains its purchasing power all the way through maturity. But it's kind of a do-it-yourself project because, in theory, you're supposed to take that part and reinvest it into your own principle so you maintain that purchasing power.