©Laurens Swinkels - CFA Institute · Laurens Swinkels, PhD Senior Researcher Robeco Quantitative Strategies Laurens is specialized in asset allocation and stock selection strategies

Inflation hedging with real assets

Laurens Swinkels, PhD

Quantitative Strategies

Dublin, 28 August 2009

© Laurens Swinkels

Inflation hedging with real assets 2

Inflation: Past, today, future…?


Inflation rate

-10

-5

0

5

10

15

20

25

30

Dec

-70

Dec

-72

Dec

-74

Dec

-76

Dec

-78

Dec

-80

Dec

-82

Dec

-84

Dec

-86

Dec

-88

Dec

-90

Dec

-92

Dec

-94

Dec

-96

Dec

-98

Dec

-00

Dec

-02

Dec

-04

Dec

-06

Dec

-08

Ireland Ireland HICP Europe United States Netherlands

Inflation in a historical perspective


Inflation rate

-8

-6

-4

-2

0

2

4

6

8

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec -07 Dec-08

Ireland Ireland HICP Europe United States Netherlands

Inflation in the recent past


Goal and setup of the presentation

– Indicate the relation between the asset side of the balance sheet of the pension fund with the inflation targets or ambitions of the pension fund

1. Link with traditional Asset Liability Management study

2. Modelling of real pension liabilities

3. Direct ways to hedge inflation risk

4. Indirect ways to hedge inflation risk

5. Summary


Link with traditional ALM study

Characteristics of a traditional ALM study

– Interaction of all policy instruments (contributions, indexation)

– Today: focus on investment policy only

– Long horizon (typically > 15 years)

– Today: focus on planning horizon (1-3 years)

– Addition of non-linear derivative instruments

(like options and swaptions)

– Today: focus on underlying asset classes

Dutch indexation label that indicates how likelyit is that pensions will be inflation protected


Modeling of inflation protected liabilities

Inflation compensation becomes a more important part of your pension onthe long run, as this liability profile of a pension fund indicates

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

2029

2031

2033

2035

2037

2039

2041

2043

2045

2047

2049

2051

2053

2055

2057

2059

2061

2063

2065

2067

2069

2071

2073

2075

2077

2079

2081

2083

2085



t=0 t=15

€ 2079€ 10005% interest

€ 2798

€ 1154

€ 867

4% interest

6% interest + 2% inflation

€ 13465% interest

€ 15544% interest

6% interest€ 1167

mark-to-market

markt-to-market

‘mark-to-market’


Euro break-even inflation term

Term structure of break-even inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Maturity

Infla

tion

(%)

08/26/2009 12/31/2008



– Higher interest rate decreased value of nominal liabilities, but wheninflation rises the value of inflation protect liabilities increases

0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5%1438 1549 1668 1796 1933 2079 22361334 1334 1334 1334 1334 1334 13341337 1441 1551 1670 1797 1933 20791241 1241 1241 1241 1241 1241 12411244 1340 1443 1554 1672 1798 19341154 1154 1154 1154 1154 1154 11541158 1247 1343 1446 1556 1674 18001074 1074 1074 1074 1074 1074 10741078 1161 1250 1346 1448 1558 16751000 1000 1000 1000 1000 1000 10001004 1081 1164 1253 1349 1451 1560931 931 931 931 931 931 931935 1007 1085 1167 1256 1351 1453867 867 867 867 867 867 867

expected inflation

nom

inal

inte

rest

rat

e

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%



– Expected inflation, break-even inflation, and expected return

Nominal rate

Break-eveninflatio

n

Real rate

Expected inflation

InflationRisk premium

Expectedreturn re

albond

Expectedreturn nominalbond


Euro break-even inflation (20yr)


Direct inflation protection

Source: Kerkhof en Swinkels (2008)

Total amount (billions) of principal outstanding per maturity on HICPxT



– Inflation-linked bonds; inflation protection always in combinationwith credit risk on governments (e.g. Italy and Greece)

Break-eveninflation

Realizedinflation

At maturity, the pension fund pays the counterparty the break-even inflation and receives from the counterparty the realizedinflation over the period

To mitigate counterparty credit risk as a result of mark-to-market valuation during the life of the swap, a well-executed collateral management process should be in place



Source: Kerkhof en Swinkels (2008)

Estimated trading volume (millions) in the inflation swap market


Indirect inflation protection

– Limited possibilities to buy direct inflation protection (certainly at the macro level)

– Analyzing inflation-protecting real asset classes by investigatingthe correlation with inflation-linked government bonds

– Useful to know whether current portfolio already contains asset withinflation-protection

– Problems for empirical research:

– No data series with long history available

– No availability at all for inflation of individual European countries(except for France); basis risk, also with respect to wage inflation

– Relatively little (recent) periods with high inflation

– At Robeco we investigated this in more detail last year – resultsof that research correspond to “non parametric model” (= lookingat pictures) in the next slides



Conclusion 1: Listed real estate and equities seem to benefit fromdecreasing inflation; so no inflation hedge

Conclusion 2: Inflation and commodities increase and decreasesimultaneously; so inflation hedge

Inflation hedging in the US in the '70s

3.4%

8.5%

11.6%

6.8%

4.7%

-60%

-40%

-20%

0%

20%

40%

60%

80%

1972 1973 1974 1975 1976

Inve

stm

ent r

etur

n

0%

2%

4%

6%

8%

10%

12%

14%

Infla

tion

rate

Equities Real estate Commodities Oil & Gas Equities Inflation rate



Conclusion 1: Commodities are best indirect inflation hedge

Conclusion 2: In 2008, all asset classes were a good inflation hedgeInflation hedging in the US in the recent years

3.5%

4.1%

0.1%

2.5%

3.2%

1.9%

2.4%

-60%

-40%

-20%

0%

20%

40%

60%

80%

2002 2003 2004 2005 2006 2007 2008

Inve

stm

ent r

etur

n

0%

1%

2%

3%

4%

5%

Infla

tion

rate

Equities Real estate Commodities Oil & Gas Equities Inflation rate


Summary

– Implicit or explicit ambition to compensate pensioners for priceincreases should be reflected in the investment portfolio

– Direct inflation protection is available in financial markets

– Not on a large scale, but for smaller funds it is possible

– Solutions with government bonds or inflation swaps

– Indirect inflation protection has historically been most clear byinvestments in commodities

– Indirect real estate and equities of commodity companies are lesssuitable as inflation hedge instruments


Appendix A: Allocation to commodities

Source: Nijman en Swinkels (2008)


Appendix B: Uncertainty on expected returns

Source: De Groot en Swinkels (2008)


Short resume

Laurens Swinkels, PhD Senior ResearcherRobeco Quantitative Strategies

Laurens is specialized in asset allocation and stock selection strategies. He advises institutional clients on investment portfolios tailored to new financial regulations. Prior to joining Robeco in 2004, he was Quantitative Analyst at Pension Factory and ABP Investments. Laurens is also assistant professor of Finance at Erasmus University Rotterdam and member of the board of PensioenfondsRobeco. Laurens obtained his MSc in Econometrics and PhD in Finance from Tilburg University, the Netherlands. He is registered with the Dutch Securities Institute

Contact: [email protected]

www.robeco.com/quantpeople.few.eur.nl/lswinkelswww.europeanpensionacademy.eu


Robeco Quantitative Strategies

The team

� Experience: team founded in early nineties

� Critical mass: 15-20 dedicated quant researchers

� Quality: strong academic credentials and links

� Focus: develop models that work in practice

� Synergy: close cooperation between different

research areasJoop Huij from QS wins the

2008 ERIM Dissertation Award

Quant products

� Equity enhanced indexing, 130/30 and long/short

strategies for developed and emerging markets

� Fixed income active duration strategies

� Conservative equity strategy

� Combined AuM € 12.5 bln

� Broad range of models for other decisions

Other research

� Asset liability management and strategic asset

allocation advisory for institutional investors

� Risk management quant support

� Knowledge sharing with papers and trainings

Robeco QS provides customized

trainings for clients around the world

Some highlights

� Long, exceptionally strong track-record for Lux-o-

rente fund based on quant duration strategy

� Highly prestigious clients such as PGGM and FRR

� More than 35 publications in peer-reviewed

academic journals

� Pioneer with launching a unique emerging

markets 130/30 fund in early 2008

Morningstar Rating

Robeco Lux-o-rente:

��

Top-level publications can

be a spin-off of our research

David Blitz and Pim van Vliet from

Robeco QS win a 2008 Emerald

Citation of Excellence Award


Disclaimer

This document has been carefully prepared by Robeco Institutional Asset Management B.V. (RIAM). It is

intended to provide the reader with information on RIAM’s specific capabilities, but does not constitute a

recommendation to buy or sell certain securities or investment products. Investment decisions should only

be based on the relevant prospectus and on thorough financial, fiscal and legal advice.

The content of this document is based upon sources of information believed to be reliable, but no warranty

or declaration, either explicit or implicit, is given as to their accuracy or completeness. This document is not

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distribution or use would be contrary to local law or regulation.

Historical returns are provided for illustrative purposes only and do not necessarily reflect RIAM’s

expectations for the future. Past performances may not be representative for future results and actual

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©Laurens Swinkels - CFA Institute · Laurens Swinkels, PhD Senior Researcher Robeco Quantitative Strategies Laurens is specialized in asset allocation and stock selection strategies