June 18, 2022

How Alternative Strategies Protect Purchasing Power

The highest inflation in a generation is having a shocking effect on both individuals’ daily spending and long-term savings. While its causes may vary, inflation is often driven by too much demand chasing too few goods. As inflation destroys the purchasing power of savings over time, investors likely need higher returns relative to what public market investment models currently offer. Adding alternative strategies to a traditional portfolio may enhance an individual’s potential to achieve their investment goals.

Inflation Drivers

Prices for certain goods and services may fluctuate as an economy adapts to temporary production shortages and excess inventory resulting from changing consumer purchasing patterns, such as millennials prioritizing experiences over possessions. Unlike these temporary fluctuations, inflation is a sustained increase in the aggregate price level of an overall economy’s goods and services. There are two primary drivers of inflation. Individuals with more money and credit can cause rising demand to exceed production and pull prices higher, which may lead to increased investment and economic growth. Alternatively, when money supply increases flow through commodity prices or labor markets, rising production costs may decrease supply, pushing prices higher and causing growth to slow as consumers narrow their spending to necessities. Underlying both types of inflation may be excessive growth in the money supply.

Measuring Inflation

The Consumer Price Index (CPI) measures the weighted average of prices for a basket of goods and services such as food, energy, clothing, housing, transportation and medical care. Food and energy are often excluded from measuring core inflation as their prices may be more volatile due to commodity cost fluctuations and seasonality. Aggregate inflation affects the cost of living differently for individuals based on their own spending priorities. Increases in housing or transportation prices will impact those in the market to buy homes or cars, while rising medical care costs may disproportionately burden the elderly. The Producer Price Index (PPI) measures the change in prices received by producers for goods and services. The PPI is from the perspective of the seller, in contrast to the CPI, which is from the purchaser’s perspective. In addition to the impact on one’s cost of living when saving for retirement, individuals should be aware of additional inflation measures that may impact their financial goals, such as paying for their children to attend college. The Higher Education Price Index (HEPI) measures the average prices of a fixed basket of goods and services purchased by colleges and universities for operational costs such as faculty salaries to determine the increases in funding sources such as the tuition, room, and board necessary to maintain their budgets. Since its inception in 1978, the HEPI has far outpaced the CPI.


Inflation Today

In May 2022, inflation increased the most on an annual basis in nearly 40 years. The CPI increased 8.6%, the largest 12-month increase since December 1981. The energy component rose 34.6%, the most since September 2005, while the food component increased 10.1%, the first increase of 10% or more since March 1981. [https://www.bls.gov/news.release/archives/cpi_06102022.htm] Today’s inflation appears to consist of both demand-pull and cost-push drivers arising from a complex and challenging economic environment. The global COVID pandemic that began in 2020 led governments to provide direct fiscal stimulus payments to corporations and individuals to sustain demand by maintaining workforces, supporting idled workers and extending unemployment benefits. In addition, central banks provided monetary stimulus through additional credit capacity by directly purchasing government and corporate bonds. However, supply chain shocks from global outbreaks, regional economic lockdowns, and local facility closures led to an initial sharp decrease in production and ongoing disruptions. The recent Russian invasion of Ukraine has exacerbated global supply chain dislocations and inflation, due in part to sanctions on Russian energy sources and interruptions of Ukrainian food exports. After an initial plunge in production and prices, the inflationary aftershocks varied. Working from home initially lead to rising home prices and vacation rental rates as white-collar workers avoided exposure by leaving densely populated cities. These remote workers also drove used car price inflation, while new car production assembly lines slowed due to semiconductor supply chain woes. As economies began to reopen, renewed demand began to outstrip the rebound in production. Direct stimulus payments put upward pressure on labor costs as some individuals refrained from returning to the workforce, whether to supervise remote schooling or wait until vaccines reduced the risk of severe illness and death. Vaccines have helped economies return to a new normal as cities awaken from the return of workers to the office a few days a week on average. But urban rents are rising due to a flood of residents and limited construction in the interim. Over a longer time horizon, persistent inflation devalues savings at a rapid rate, as a dollar today will buy less each year. Inflation even erodes the real returns on savings that are invested. Therefore, one’s investments need to work harder to preserve and enhance purchasing power. Adding alternative investment strategies to a traditional portfolio may improve an investor’s potential for risk-adjusted returns that outpace inflation.

Investment Models & Inflation

Portfolio strategies diversify investments to balance performance based on their different risk profiles and return potentials. The goal is to achieve strong returns while mitigating downside risks from market-related volatility or poor performance due to concentrated positions. By diversifying portfolios, the positive performance of some investments may offset the poor performance of others based on their underlying fundamentals and investor sentiment. Diversification also takes into account how investments respond differently relative to each other, and in some cases the opposite direction due to market volatility. The degree to which investments change in value relative to or inversely from each other is known as correlation. The less correlated a portfolio’s investments are, the greater the diversification benefits. A popular portfolio model seeking capital appreciation, current income, and diversification to hedge against volatility from uncertainty and inflation allocates 60% of assets into stocks and 40% into bonds. This mix of securities has the potential to deliver higher returns from stocks than inflation and steady returns from interest received from bonds, as well as low correlations between the two asset classes historically. Rebalancing holdings periodically based on investment performance back to the portfolio model’s 60/40 allocations may enhance the potential for positive returns and lessen volatility. For example, if stocks have declined and represent less than 60% of the portfolio, rebalancing results in buying more stocks at lower prices. To address limitations of the relatively static 60/40 portfolio, a retirement target date investment model adjusts the mix of stocks and bonds during an investor’s career and after they retire. Target date funds address the need for growth to reduce the risk of outliving one’s savings in retirement by having a much greater allocation to stocks than the 60/40 model early in an individual’s career. Over time, target date funds dynamically shift their holdings more toward conservative bonds to preserve wealth and provide income. Target date funds are also periodically rebalanced to maintain the model’s mix of stocks and bonds relative to an investor’s retirement date. However, both static and dynamic asset allocation models have potential risks in the current environment that may impede meeting an investor’s financial goals. The monetary stimulus by central banks since the Global Financial Crisis in 2009 caused interest rates to fall to record lows. As a result, the returns from the investment models’ hefty allocations to bonds have underperformed historical results since the crisis began over 10 years ago. Rebalancing has only compounded the problem following recent periods of stock market gains as more low-yielding bonds were bought. In addition, the massive liquidity inflows into public markets led to increased correlations in investment returns between stocks and bonds, lowering the benefits of diversification. Now, central banks are withdrawing stimulus to reign in inflation by raising interest rates and selling bonds. The impact on investment portfolio bond allocations is likely a decline in prices inversely related to rising rates, while the low embedded yields of prior bond purchases are unlikely to provide a sufficient hedge against rising inflation. At the same time, rising rates are likely to impact corporate profit margins, earnings, and cash flows. As a result, the even more hefty stock allocations of the investment models are likely to be more volatile as valuations should contract, exposing investors near or in retirement to the risk of incurring permanent capital losses.

How do Alternatives Enhance Returns to Outpace inflation?

Alternative investments may provide uncorrelated returns that increase diversification relative to a traditional portfolio, as well as the potential for enhanced capital appreciation or income to outpace inflation. However, investors trade off the liquidity of being able to sell securities at any time through the public markets to have the opportunity to realize the performance premium that alternative investments offer through longer term strategies. Different alternative investment strategies can separately address inflation. Private equity and venture capital may provide greater capital appreciation than publicly traded stocks. Privately-owned companies also aren’t at the mercy of market volatility, which may be uncorrelated to returns based on a company’s fundamental improvements. At the same time, private credit may offer greater income than public debt securities. Terms can include floating rates that increase with rising market interest rates to hedge against inflation, while returns are uncorrelated to fixed-rate securities. In addition, private real estate can offer both income and capital appreciation while historically being uncorrelated to stocks. Furthermore, hedge fund strategies can mitigate risks by seeking to deliver relatively steady equity-like performance with uncorrelated returns achieved by reducing systematic market risk exposures.

Poolit Provides Access to Alternative Strategies to Fight Inflation

Historically, alternative strategies have been only accessible to institutional investors such as university endowments and pension plans, or high net worth individuals considered to be qualified purchasers by having a net worth of over five million dollars excluding home equity. Individuals also lacked access to fund manager distribution channels or their large wealth management partners in order to make investments. We are convinced that everyone should have the opportunity to generate meaningful wealth, so we left Wall Street to rebuild it for you. Poolit is seeking to offer accredited individuals the opportunity to invest in the same potential risk-adjusted returns to outpace inflation offered by alternative strategies previously accessible only by institutions and high net worth investors. Partnering with professional alternative investment managers through a registered fund, Poolit’s offering will provide broad exposure to private market strategies in a single investment. To further democratize alternatives, the fund will also have no minimum investment. To begin building your wealth and realizing your potential, get early access and be the first to know about new alternative investments on Poolit by providing your email at https://www.thepoolit.com.