15 Feb A Good Alternative to Inflation
A Good Alternative to Inflation
By QP Wealth Management
February 15, 2022
Inflation continues to be one of the most sought-after topics of conversation with clients, fund managers, and the occasional dinner party. We won’t wager in on the inflation bet, but we will share ways to hedge it (pun intended) by way of alternative investments. More specifically, we’ll discuss what investment parameters to consider if inflation keeps you up at night.
We’ll start with a little inflation cause and effect. Inflationary periods are characterized by higher prices for goods and services. In an inflationary environment the Federal Reserve is likely to raise interest rates to slow the economy (and in effect, inflation itself). When interest rates rise it costs more to borrow prompting both consumers and businesses to borrow less. It could also trigger banks to increase their interest rates. This would earn consumers more on their savings, theoretically prompting more saving and less spending. An increase on savings rates could lag initial rate hikes significantly depending upon how cash-heavy bank balance sheets are. As it relates to the stock market, inflation is generally seen as negative as it reduces earnings growth expectations putting downward pressure on stock prices. How these considerations play out across each asset class depends on the fund manager’s positioning and use of vehicles that provide an inflation hedge. It all sounds bleak, so how can an alts investor set out to outpace inflation?
Private credit partnerships typically deploy floating rate loans. Floating rate loans derive income from a fixed spread plus a floating rate which adjusts periodically alongside a particular index or benchmark rate. In the event of an interest rate hike, the floating rate component would be triggered. In contrast, fixed rate vehicles lose earning potential as prices fall when interest rates rise. In a rising rate environment, a fund manager may allocate more heavily towards floating rate vehicles to hedge interest rate risk. Keep in mind when interest rates rise borrowers tend to do less borrowing. This is where fund managers with deep relationships and access to resources have a history of pulling away from the crowd.
Private real estate is best covered by sector as some are better equipped than others. Multi-family investments are characterized by short-term leases (usually one-year) which can be adjusted to mitigate the effect of rising interest rates. In sectors with longer term leases (i.e. industrial, triple net lease, retail, office, etc.) look for clauses setting contractual guidelines for annual rent increases. Some sectors of private real estate have little or no income component such as development or heavy value-add investments. These strategies seek appreciation in asset value, have longer investment timeframes, and no immediate income component. Most importantly, in the context of the subject matter, these are considered hard assets which historically serve as an inflation hedge; their intrinsic value moving in tandem with inflation.
Hedge funds are chameleons, capable of adapting to their environment. A hedge fund is a highly flexible, actively pooled investment fund that typically utilizes complex investing strategies (options, derivatives, leverage) to achieve their objective. These strategies may include reducing volatility, producing outsized returns or a combination of both. Their freedom to go both long and short can give them the advantage of being able to play both sides of the inflation trade. Due diligence and a focus on overall investment objective are going to be critical factors here. Not all hedge funds are created equal.
Private equity, much like a hedge fund, can benefit from its ability to adapt to succeed. These funds can get innovative in strategy and investment selection, targeting opportunities in sectors that bode well in an inflationary environment. Companies with low overhead, strong products, and strong market share should face less difficulty maintaining revenues. It’s also important to remember that prudent fund managers build their pricing assumptions with a range of best- and worst-case scenarios in mind, inflation being no exception.
As we highlight inflation benefactors, it’s also worth noting what to be weary of. Leverage can be used in any of the above strategies. Leverage is the use of borrowed capital to fund an investment with the expectation that the return will be greater than the interest due. The mechanism behind this leverage can be fixed of floating, so it’s important to distinguish between the use of the two to assess potential inflation risk. As interest rates rise, the extent and nature of leverage used could meaningfully mute returns.
The strategies and traits we covered are not unique to each asset class and they are not the only consideration to be made when assessing an alternative investment fund. Manager selection and assessment of overall investment objective are incredibly important. Alternative investment managers have had inflation in their rear-view mirror for quite some time, evaluating how they’ve prepared and positioned for it should be an essential part of the due diligence process.
The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated.
QP Wealth Management is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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