Returns and Volatility in Inflation Hedging: REITs, TIPS and Commodities
In addition to delivering increased returns when the CPI rises, a truly effective inflation hedge should provide returns great enough to offset the effect of inflation, plus meet the disbursement requirements of plan participants who depend on these funds for their living expenses. Because living expenses are a constant, the inflation hedging investment also must produce its returns on a relatively constant basis, with limited volatility.
In addition to REITs and other real estate, two commonly used inflation hedges are Treasury Inflation Protected Securities (TIPS) and commodities. TIPS provide sure protection against inflation by building the inflation rate into the income earned on a medium to long-term U.S. Treasury bond. Every six months, the principal on the bond is adjusted based on the level of the consumer price index at that time. The investor receives an interest payment equal to the adjusted principal multiplied by one-half the stated interest rate for the bond.
The trade-off for this assurance comes in the form of lower returns. Over the past 30 years, the CPI averaged 4.2 percent annually, which would have consumed half of the average 8.3 percent annual return from TIPS. By comparison, both commodities and REITs would have provided superior returns for meeting obligations to plan participants, with 10.3 percent average annual returns for commodities and 14.2 percent average annual returns for REITs.
REIT, TIPS and Commodity Returns. Source: NAREIT.
The commodity returns over this period, however would have come at the price of far greater volatility. The standard deviation of monthly returns for commodities over the 30-year period has averaged 4.87 percent, compared with 1.60 percent for TIPS and 3.63 percent for REITs.
REIT, TIPS and Commodity Returns. Source: NAREIT.
The Sharpe ratio, which measures excess returns divided by volatility, provides a measure of risk adjusted investment performance. Over the past 30 years, equity REITs have delivered a Sharpe ratio of 2.43 percent, superior to both commodities at 0.63 percent and TIPS.
REITs Deliver Superior Risk Adjusted Performance. Source: NAREIT.
The combination of superior returns and low volatility makes REITs an inflation hedge that also provides superior portfolio benefits in non-inflationary environments. Over the past 30 years, during months when inflation has been higher than average, REITs substantially outperformed TIPS and equaled the S&P 500, although they fell slightly short of commodities.
REITs provide a powerful hedge in high-inflation periods. Source: NAREIT.
On the other hand, during quarters when inflation was lower than average, REITs substantially outperformed TIPS, commodities and the S&P 500.
REITs deliver superior returns to other inflation hedges in low-inflation periods. Source: NAREIT.