Preparing for higher inflation: Portfolio solutions using U.S. equities

• DOI: http://doi.org/10.1002/rfe.1091
• Date: 01 July 2020
• Published date: 01 July 2020

542

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:542–554.

© 2019 University of New Orleans

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INTRODUCTION

Investors are always interested in reducing inflation risk in their portfolios. Inflation reduces the purchasing power of investors

and redistributes wealth from lenders to borrowers. As with any other risk in the financial market, the investor might want to

mitigate the risk exposure by adjusting the portfolio's composition. To protect against inflation, researchers have proposed dif-

ferent asset classes as inflation hedges such as inflation‐linked bonds (Campbell, Shiller, & Viceira, 2009; Dudley, Roush, &

Steinberg, 2009; Shen, 1998), common equity (Anari & Kolari, 2001; Ang, Brière, & Signori, 2012; Boudoukh & Richardson,

1993; Ciner, 2015; Schotman & Schweitzer, 2000), real estate (Hartzell, Hekman, & Miles, 1987; Martin, 2010), commodities

(Bodie, 1983; Gorton & Rouwenhorst 2006; Kat & Oomen, 2007), and infrastructure (Rödel & Rothballer, 2012). For a detailed

survey on inflation‐hedging using different asset classes, see Attié and Roache (2009) and Greer (2005). In this paper, we focus

on common equities in a portfolio setting for hedging different types of inflation.

Numerous studies from the mid 1970 to the early 2000s have reported that equity markets in the aggregate have exhibited-

poor inflation‐hedging characteristics (Bekaert & Wang, 2010; Fama, 1981). Boudoukh and Richardson (1993) find that ex post

nominal stock returns and inflation are negatively correlated. Financial economists view this result surprising since stocks, as

claims against real assets, should compensate for movements in inflation. Similarly, a negative relationship exists between ex

ante nominal stock returns and ex ante inflation.1

Since the Fisher model implies that expected nominal rates should move one‐

for‐one with expected inflation, this negative correlation strikes at the heart of one of the oldest and most respected financial

Received: 19 August 2019

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Revised: 10 October 2019

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Accepted: 10 October 2019

DOI: 10.1002/rfe.1091

ORIGINAL ARTICLE

Preparing for higher inflation: Portfolio solutions using U.S.

equities

HarshParikh1*

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Rama K.Malladi2

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Frank J.Fabozzi3

*Disclaimer: For Harsh Parikh the views and opinions expressed in this article are those of the author and do not necessarily reflect the position of PGIM or

any of its affiliated entities.

1PGIM, Newark, NJ, USA

2California State University, Dominguez

Hills, CA, USA

3EDHEC Business School, Nice, France

Correspondence

Rama K. Malladi, Department of

Accounting, Finance, and Economics

(CBAPP, SBS C‐315), California State

University Dominguez Hills, Carson, CA

90747, USA.

Email: rmalladi@csudh.edu

Abstract

Investors have always been interested in reducing inflation risk in their portfolios.

However, investors face different types of inflation than those measured by the

Consumer Price Index (CPI). Moreover, different asset classes can be used to hedge

portfolio inflation. In this paper, we show how individual equities can be used to con-

struct equity portfolios sensitive to customized inflation targets. We illustrate portfo-

lios for three types of inflation: US headline CPI, Forbes Cost of Living Extremely

Well Index, and the US Medical Care Price Index. We also show how alternative

weighting schemes, such as minimum volatility and maximum inflation beta, can be

used to construct inflation‐hedged portfolios.

KEYWORDS

asset management, inflation beta, inflation hedging, inflation indices, inflation‐sensitive equities

JEL CLASSIFICATION

G11; G23