Interestingly, four asset classes not normally associated with real return—bank loans, high-yield, convertibles, and local currency emerging markets bonds—provide inflation protection that is comparable to, or better than, TIPS. Bank loans surprisingly offered an even higher correlation than commodities! All four of these “underrated inflation fighters” had a more direct link with rising prices than infrastructure and timberland.

These data invite the question: “Why not deploy a full roster of asset classes in a real return portfolio?” We find that a true inflation-hedging portfolio should have a broader tool kit than just conventional real return assets like TIPS, real estate, and commodities.

A Tactical Overlay

Many investors adhere rigidly to a long-term asset allocation rather than tactically moving among the asset classes. Such an approach tends to hurt investors in the tough times. Consider what happened in the worst inflationary period in the United States over the past 100 years. From January 1977 through April 1980, year-over-year inflation ramped up from 5% to over 14% in less than 3½ years. During that period, most asset classes failed to deliver returns in excess of inflation.

As Table 2 shows, commodities and REITs finished near the top of the list. Surprisingly, the best-performing asset class—at 14% real—was U.S. small cap. International equities offered the best real return Sharpe ratio—not commodities and not REITs![1] As expected, long bonds were the worst-performing asset classes, with long credit and long Treasury indexes producing real returns of approximately -11.5%. On a cumulative basis, this translates to a 40% loss of purchasing power. Isn’t this what real return mandates are supposed to protect against?

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