Inflation-Protecting Asset Allocation: A Downside Risk Analysis

ERES Conference, 5th July 2013

Tim Koniarski, Steffen Sebastian

2Inflation-Protecting Asset Allocation

Motivation

The study is motivated by two facts:

(1)Previous studies only focus on correlations between asset returns and the

inflation rate to investigate the inflation-protecting abilities of assets analysed.

(2)In the asset allocation context the variance is used as risk measure to

determine optimal inflation-protecting portfolios.

3Inflation-Protecting Asset Allocation

Contribution

• We analyse horizon-dependent inflation-hedging abilities of the assets

(cash, bonds, stocks and direct commercial real estate) using lower partial

moments and compare the results to VAR-implied correlations.• Account for asymmetric returns by bootstrapping multi-period returns.• Augmented by transaction costs.

• Determine optimal inflation-protecting asset allocations within 2nd order

LPM (CLPM) framework.• Variation of target returns.

4Inflation-Protecting Asset Allocation

VAR approach

• VAR model includes asset returns and additional state variables (dividend-

price ratio, term spread, cap rate and inflation)

• VAR-implied variance:

• Multi-period returns are bootstrapped according to Benkwitz et al. (2001).

5Inflation-Protecting Asset Allocation

Lower partial moments

• Downside risk measure: Lower partial moments (LPM)

• The LPM of order n is estimated by

where is the target rate and is the return of asset i with T

observations.

• Focus on • LPM of order n = 0, the shortfall probability• LPM of order n = 1, the expected shortfall• LPM of order n = 2, semivariance

6Inflation-Protecting Asset Allocation

Co-lower partial moments

• Portfolio context: Taking into account co-movements between assets

• According to Estrada (2008), a co-lower partial moment between asset i

and j is defined as

• The resulting symmetric semivariance matrix is used for the portfolio

optimization problem.

7Inflation-Protecting Asset Allocation

Data set

• Quarterly US data from 1978:Q1 to 2010:Q4.

• Direct real estate returns are desmoothed appraisal-based returns with the

method proposed by Geltner (1993).

8Inflation-Protecting Asset Allocation

VAR parameter estimates

9Inflation-Protecting Asset Allocation

Correlations between asset returns and inflation

10Inflation-Protecting Asset Allocation

Inflation-protecting qualities of assets

11Inflation-Protecting Asset Allocation

Minimum semivariance portfolios, target 0%

12Inflation-Protecting Asset Allocation

Minimum semivariance portfolios, target 1+2%

13Inflation-Protecting Asset Allocation

Conclusion

• Considering correlations to investigate inflation-hedging potential of assets

can imply false conclusions.

• Inflation-protecting abilities of assets change substantially over the

investment horizon.• Cash performs best in the short run, but worst in the long run.• Real estate protects investors best against inflation for longer investment

periods.

• These changes also affect optimal inflation-protecting asset allocations.

• Investors requiring a higher real return allocate more volatile assets on a

medium and long-term basis.