Alternative Investments for Periods of Inflation

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Michael Sager, executive director, Multi-Asset and Currency Management at CIBC Asset Management.

With the highest inflation in decades and interest rates set to rise further, which alternative strategies do we recommend and why? Well, I think it’s important when we think about the role of alternatives in portfolios to just step back a little bit and think about the overarching theme of portfolio construction. And that overarching theme really should be to build a portfolio that maximizes the ability of each and every investor to achieve their long term investment performance objectives. So to our mind, that requires a focus on equity risk as the cornerstone of portfolios, because historically equity has been the main source of financial wealth creation, and looking out into the long term in the future, we expect that it will remain the cornerstone as far as the eye can see.

It also makes sense in portfolio construction to embrace other asset classes that can diversify equity risk, and may offer the opportunity to smooth out some of the impact of periodic market volatility, such as we’re seeing now at the beginning of 2022. I think this is where alternatives have an important role, but the descriptor alternatives is very, very broad. So we have to see alternatives as a large set of complementary investment solutions, and then we have to ensure that we allocate for those alternatives that best serve our specific investment objectives. In the case of a need to protect portfolios from inflation and rising interest rates, it can make sense to allocate to what we call absolute return strategies. These are very flexible solutions and very different from traditional investment solutions.

If you think about a traditional 60/40 balanced portfolio, they tend to be long on the investments and tend to be very closely linked to an underlying benchmark index, maybe the S&P/TSX or the MSCI World. But that means that their performance is very linked to the underlying markets. So, when equity markets go up, a benchmark relative strategy will typically go up in performance. When equity markets go down, the benchmark relative solution will also typically go down. That’s why we find absolute return strategies interesting, because they’re not tied to underlying benchmarks. They can take long positions, but they can also take short positions. And that means that they can expect to generate a very different return profile, a very different performance profile to a traditional strategy.

So for instance, they also incorporate a wider set of asset classes than a traditional portfolio. Asset classes that include equities and bonds, but also include, for instance, currencies and commodities. And that’s really useful when you think about the need to protect portfolios from inflation and rising rates.

How do we do that? Well, the most sensitive asset classes to changes in inflation tend to become commodities. So let’s have some exposure in a very thoughtful way to commodities. We can do that through alternatives like absolute return strategies. When interest rates are rising, perhaps we want to be short bonds instead of just long bonds. We can do that in an absolute return alternative strategy. So, I think the importance is on understanding the specific investment objectives of an investor, but then making sure we have as much diversification and as much breadth in the portfolio as we can.