Managing inflation risk (AQR)

This Oct 2021 technical paper (10 pager) by AQR Capital Management is representative of an alternative investment strategy approach deployed by market trading hedge funds.

The paper is titled – When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios.

AQR, renowned for its academic research and quantitative rigor, was an early proponent, since its founding in 1998, of diversification within portfolios, as well as adding strategies with low correlation to traditional asset classes as a complement to existing portfolios.

Most investors and financial advisors deal with inflation at only the asset diversification level, “Let’s re-allocate capital to more defensive, inflationary-resistant asset classes.”

Firms like AQR are practitioners and advocates for investment strategy diversification. (Read a primer on strategy/trading model diversification here.)

The premise of AQR’s paper is that we are experiencing an “unprecedented monetary stimulus, dating back to the Global Financial Crisis, coupled with extraordinary fiscal stimulus and potential supply chain disruptions stemming from the Covid-19 pandemic, has raised renewed concerns about the potential for upside shocks to inflation.”

Source: AQR

In today’s inflation dominant period, we see the breakdown between equities and bonds (U.S. Treasuries). i.e. Bonds no longer serve as a good hedge to equities as both asset classes tend to underperform.

AQR’s research conclusion is that application of both trend following and macro momentum strategies provide quantitatively superior portfolio diversification – and increased probability of outperformance in volatile market conditions.

“By studying alternative assets we can identify potential solutions. Some real assets, notably commodities and inflation breakevens, have meaningful positive inflation sensitivity, though real estate and unhedged TIPS show negative and near-zero inflation correlations respectively. In addition, active strategies such as trend following and macro momentum show positive convexity to the inflation environment, i.e., the opposite characteristic to that of equities.”

Source: AQR

Trend following and momentum strategies are supported by over a century of academic evidence. (See this Barron’s article behind a paywall.) This Oct 2021 paper serves to quantify and reinforce AQR’s investment approach.

When it comes to navigating volatility and harvesting the upside potential during an inflation period, AQR and Alphalytics think and execute beyond asset class diversification.

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