If Janet Yellen is confirmed to lead the Fed, risk managers and strategists will have to consider the possibility of inflation. Her “optimal control” models place greater emphasis on unemployment and less emphasis on controlling inflation.
Inflation, once started, can be very difficult to control. It can come in two varieties: an inflationary boom, which is more or less desired by the Fed, or the much less-attractive stagflationary environment.
In this special report, we will identify mutual fund investments that are likely to perform well in these two inflationary scenarios. We will also build in these additional criteria â€” a high yield and low expense ratio.
Risk management seems to be a household topic these days. No longer an exclusive province of quants, it is discussed regularly by the popular press. From the shortcomings of value-at-risk to the latest stress tests imposed by the Fed on banks, risk management has gone mainstream. But why has it failed so dramatically in 1998, 2000, 2007, 2008 and again in 2010 with the European debt crisis? We will argue that too much focus has been placed on backward-looking risk measures and not enough on stress testing. We will show that stress tests can be useful not only for risk managers, but for strategists as well.
Why stress testing?
Why do we need stress testing when we already have risk measures like Sharpe ratio, beta, value-at-risk, tracking error, expected shortfall? The problem with VaR, Sharpe ratio, beta and others on that list is that they are completely backward-looking. A tracking error or a Sharpe ratio at this point in time has no clue that interest rates can actually rise by more than trivial amounts, since nothing of that kind was observed in the data sample.
Moreover, if you ask one of these measures about the possibility of a simultaneous rise in interest rates and a drop in equities, it will likely tell you that the probability of such a one-two punch is zero. When those measures will gain that knowledge, it will be too late to be useful, since the events will have already happened. Backward-looking risk measures still view long-dated Treasuries and any instruments with a great deal of interest rate risk as virtually riskless, due to the low volatility and safe haven appeal that we have observed over the past decades. This will lead you to underestimate probabilities of events that are quite plausible in the next few years, such as high inflation or stagflation.
Incorporating expert input
We don’t know the timing but we do know that interest rates are likely to rise over time from these historically low levels. We know, for example, that they can rise concurrently with a drop in the equity markets; we sampled a taste of that during the past few months when the Fed announced its unfulfilled QE taper threat. So, we need some risk measure that is not tied exclusively to the past, but can incorporate some expert input.
Factor based stress testing is exactly such a measure. It allows for creation of various macroeconomic scenarios and estimation of gains/losses under those scenarios for a wide range of instruments.
How is ability to enter expert input going to help us in identifying top performers in inflation/stagflation? We can create a scenario where interest rates at the long end of the curve and commodities rise simultaneously. Our scenario is going to consist of two shocks, a 300 bp rise in the 30 year Treasury rate and a 70% move up in gold, and the risk model will imply the shocks to the rest of the factors [for quantitative mechanics, see this paper.
No risk model contains such moves in its past sample, because we haven’t really seen any significant inflation in at least three decades. This is really the more optimistic inflationary boom scenario where equities will rise when interest rates do. We will look for mutual funds that will perform the best under this scenario, limiting our results to funds that also have some yield and relatively low expense. In order to do that, we must calculate the impacts of inflation stress testing on a wide universe of mutual funds and ETFs, then sort by performance under inflation and filter by dividend yield (>5) and expense ratio (<.75). Table 1 shows the results.
Table 1: High yield, low expense, strong performance in inflationary boom
Source: www.fundcrashing.com / Lipper
Variety is the spice of funds
We can see that our resulting funds come from a variety of Lipper categories. We see rows with names of the funds and columns indicating dividend yield, expense ratio and performance in inflation.
The top performer is PSTKX (PIMCO StocksPlus) fund. It has a return of 33.7% under inflation stress test and dividend yield of just over 5% (expense ratio of .5). The next fund is DFA Global Real Estate Securities with a return of 29.5. On the right we see detailed stress test diagnostics stretching beyond the inflation scenario for a fund that we selected on the left â€” BlackRock Multi-Asset Class Income Fund (BIICX). In addition to having 14.6% return in inflation, it has a yield of over 5% and an expense ratio of .73. In the crash test diagnostics on the right we can see that its peer group crash rating is 4, meaning that its risk is generally below median in the Global Flexible Port Funds Lipper category.
As we noted, the best inflation performers come from a number of peer groups, but there is a common theme. They all look to be either high yielding real estate exposure funds (real estate usually holds its real value when inflation rises nominally) or funds that have significant exposure to the equity part of the capital structure (including high yield, which behaves much like equity) while keeping the yield relatively high (our yield >5% filter).
Hunting the stagflation bear
No investment firm ever got in trouble by missing a single crisis. The financial system is a zero sum game by construction, at least in the short run, so most firms will miss most crises by construction. If they don’t, those crises simply won’t happen. Surprises await portfolios not when a certain asset or asset class is losing big, but rather when different parts of the book start losing together (like interest rates rising and stocks dropping at the same time). This is the contagion effect.
Stress testing is uniquely suited to dealing with it, because we can specify shocks that were not observed historically and see how funds and portfolios respond. Instead of being an enemy, contagion can become your friend. In addition to the inflation stress test we outlined before, we will create another one and call it “stagflation.” Stagflation is different from the inflationary boom because equities will be going down, rather than up. Before the 1970s, most economists did not think that it was possible to have a depressed economy during an inflationary period, that inflation was simply a price that could be paid for a boom. However, an inflationary boom could turn into stagflation in a number of ways with unexpected correlation shifts. It could happen, for example, after a supply shock to energy (like in the 1970s) or to food coupled with expansionary monetary policy. Table 2 shows us the best performers in a stagflation scenario filtered by yield and expense ratio, similarly to the previous table.
Table 2: High yield, low expense strong performance in stagflation
Source: www.fundcrashing.com / Lipper
Stubborn stagflation issues
There are a couple of points that jump out. It is very difficult to get any reasonable performance under stagflation with a decent yield. When we filter by yield, the best performance we can get is 8.45% for Janus Overseas fund. Considering that stagflation is accompanied by a significant loss of real value, this nominal return is barely enough to break even. If we remove our constraints on dividend yield, we will see that it is possible to get good performance in stagflation, but the choice is limited to funds that have very little yield.
Table 3: High performers in stagflation with low expense
Source: www.fundcrashing.com / Lipper
Summary: We have seen that an inflationary boom presents a number of opportunities to protect purchasing power while generating income and paying a low expense ratio. However, inflation coupled with stagflation and equity losses is a completely different story. The only high performers will be commodity strategies that offer no income and are very risky in non-inflationary environments.
To perform scenario analysis similar to that outlined here, go to www.fundcrashing.com.
Daniel Satchkov is president of RiXtrema Inc.
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