HedginginflationTheroleofexpectations-Vanguard.pdfVIP

Hedging inflation: The role of expectations Vanguard research March 2011 Executive summary. The growing interest in inflation hedging spotlights investors’ need for a clear understanding of the relationship between asset Authors returns and inflation.1 For those with long-term investment horizons, risky Geetesh Bhardwaj, Ph.D. assets like stocks and bonds may earn returns high enough to overcome Dean J. Hamilton John Ameriks, Ph.D. erosion in purchasing power due to inflation, on average. However, investors looking to hedge against inflation are typically concerned with short- and medium-term protection. These investors need to be aware of the difference between expected and unexpected inflation. Expected inflation is essentially the market’s consensus view on the future path of inflation; because financial markets are forward-looking, they presumably incorporate this view into current asset prices. By definition, “inflation risk” is generally a worry about unexpected inflation. Any asset being considered as an inflation hedge should be evaluated based on its relationship to both components. 1 See Davis (2007) for a detailed discussion. Connect with Vanguard  Some assets, such as commodity futures, have historically provided returns that tend to rise with unexpected inflation, while others, such as Treasury bills, have had returns that tend to rise with expected inflation. In this paper, we examine the historical correlation of these and other asset classes to both aspects of inflation. We find that a commodity futures position fully collateralized with T-bills may offer some attractive features as an inflation hedge; however, investors need to be aware of the associated risks. A well-diversified portfolio of stocks, bonds, and other asset types remai