Inflation hedges that can help endowments & foundations preserve real wealth

Endowments and foundations (E&Fs) haven't had to worry much about inflation over the past decade. With inflation expectations in flux, can E&Fs still meet their return objectives? We're exploring this question with another look at our Institutional Insights paper, "A playbook for endowments and foundations to help navigate higher inflation." This paper was researched and written by Collin Crownover , Research Analyst, Asset Allocation Research Team and Erika Murphy, CFA, CAIA , Portfolio Manager, Global Institutional Solution. Don't miss the insights from our playbook we've already shared: Inflation’s impact on endowments and foundations and How spending policy and inflation impact return goals for endowments and foundations.

KEY TAKEAWAY:

• We believe E&Fs should consider including a dedicated allocation to inflation hedging assets to help preserve their real spending power. A variety of public asset classes may serve as an inflation hedge, including commodities, commodity related equities, and Treasury Inflation-Protected Securities (TIPS). Private assets including private equity, private credit, private infrastructure, and private real estate have also historically demonstrated a positive correlation to inflation.

A variety of other asset classes can serve as a hedge to inflation dynamics, helping to potentially boost E&F returns and real wealth in periods of elevated inflation. Importantly, however, there is no single inflation hedge that works in all market conditions. Rather, selection and sizing of these inflation hedges should vary depending on the level of inflation, inflation’s rate of change, the level of economic growth, as well as of course the risk profile of the inflation hedging asset class itself. To better understand the importance of these conditions, we review some of these historical relationships below.

Level of inflation

Certain asset classes have demonstrated better real performance during periods of elevated inflation environments. In terms of public market exposures, natural resources equities and commodities tend to generate strong returns during periods of high inflation, helping to offset lower returns from equities and bonds (Exhibit 5). Within fixed income, TIPS have provided an avenue of lower-risk inflation protection as well, as these have historically provided positive returns and outperformed core bonds in periods of elevated inflation.

While the return history is shorter for private assets, our analysis shows that private equity, private credit, and private real estate have also provided inflation-hedging return characteristics on average during periods of high inflation, as seen in Exhibit 6 (8). These assets have generated materially higher levels of return versus public assets in the past, so the sheer level of returns in private equity and private credit have been helpful to E&Fs with 5% real return objectives. This is in part driven by the fact that payout ratios for private equity over a 10-year horizon have been significantly higher than dividends and buyback payouts in public equities, while private credit loans tend to be floating rather than fixed rate. While private asset returns may not always be as high going forward, historical averages nonetheless suggest that private assets have given up less return in higher inflation environments compared to public assets.

Inflation’s rate of change

Critically, as shown in Exhibit 7, asset class returns can be meaningfully impacted by the rate of change of inflation as well. Generally, during historical periods of elevated (above 3%) but falling inflation, global equity returns have exceeded commodity returns, and core bond returns have exceeded TIPS returns (9). For these reasons we recommend allocators invest in these public asset classes in a dynamic fashion— reducing inflation-hedging asset classes in periods of falling inflation, and adding to inflation-hedging asset classes in periods of rising inflation (10).

Level of economic growth

Considering the economic backdrop is also important to determining the proper asset allocation during periods of elevated inflation (Exhibit 8). Generally, during periods of elevated inflation and strong economic growth, equities, natural resources equities, and commodities have historically dominated performance. Conversely, during stagflationary environments (rising inflation and weak economic growth), inflation-sensitive assets such as TIPS and certain private asset classes have been some of the only assets that delivered positive real returns.

Risk considerations

While certain asset classes can be stronger hedges to inflation, some do come with higher volatility and potential drawdown risk. For these reasons, consider that any inflationsensitive allocation be limited in size and that these risk characteristics be considered in the construction of the inflation-hedging basket. Exhibit 9 outlines the volatility and inflation correlation statistics of a range of asset classes since their respective inception dates during the post-World War II period.

For more Fidelity research on the factors impacting the real wealth of endowments and foundations during times of high inflation, check out the full playbook and other E&F solutions here.

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