Ask economist and layman alike about the recent activities of the Fed and you’ll likely hear the foregone conclusion that inflation is right around the corner. As a result, many investors are questioning whether their current portfolio is properly structured for such an environment, and, if not, what changes should they make?

A common theme among investors who fear a rise in inflation is to invest heavily in “real” or tangible assets such as gold, commodities, or real estate. Looking at the historical relationship between inflation and the above-mentioned assets, however, there is little evidence that these asset classes reliably help buffer a period of high inflation.

The table below shows the correlation between the above mentioned assets’ yearly returns and inflation over the past thirty years. Correlation is measured between -1.0 and +1.0, and captures the strength and direction of a relationship. Investors who expect inflation to go up would prefer to hold assets that have a high positive correlation (> 0.70) and avoid assets with a high negative correlation (< -0.70). Correlations that are close to zero have little to no relationship; sometimes they move together, sometimes they don’t. As such, they don’t provide a reliable hedge – and that is what we find with commodities, gold and real estate: 

Clearly these asset classes don’t live up to their reputation as inflation hedgers. In fact, gold (the asset class everyone seem intent on piling into right now) has often done the opposite of what investors expect, going down during high inflationary periods and going up during low inflationary periods, as seen in the graph below:

Using the correlation data from the table above, investors should not be surprised to see the following returns in 1980 and 1981 when inflation was running in double digits:
 

Nor should they be surprised to see the following returns 2002-2003 when inflation was running in low single digits:

Just as we would expect from the lack of correlation, there is no clear behavior pattern with commodities and gold in relation to inflation. And while real estate would appear from these examples to be the best hedge, there are many examples (such as the early 1990s) when real estate suffered big losses during a period of high inflation.

In addition to the uncertain relationship with inflation, all of the above assets have historically yielded higher levels of volatility than the broad market:

As the table above shows, investors selling equities to fund purchases of real assets are likely to actually increase their risk. Combine this with the lack of a strong relationship between inflation and these asset classes and it becomes clear that making a major shift in one’s portfolio to offset this risk is likely to be a fruitless exercise.

If there was ever a time in which active managers had the ability to prove their worth, it has been in the past year. After all, if active managers can’t foresee the worst recession and subsequent bear market since the Great Depression, what makes us believe they can see the little ones? With this in mind I recently set out to measure how active managers as a group have fared over the past year.

Using Morningstar’s database, I created a list of actively managed funds benchmarked to the S&P 500 and compared their performance to that index. For reference, I also included data for a fund every investor, big or small, has access to: the Vanguard S&P 500 fund (VFINX). The final list contained 633 actively managed, distinct funds. 

Rather than just looking at how the funds performed over longer time periods, I wanted to examine a key premise of active management – the claim that a good manager will minimize the downside and maximize the upside for you. To do this, I used a measure known as the “Downside Capture Ratio,” which is a measure of how much of the index’s return a given fund was able to capture. (Keep in mind that in a down market, you actually want to capture less of the index’s return).

As you will see in the table below, the average actively managed fund actually lost more than the S&P 500 index, capturing 100.56% of the benchmark’s loss. 

Though around 50% of the funds lost less than the S&P, for all except those in the top deciles, the difference was negligible: Keep in mind that even the top-decile funds still lost 28.37% on average.

So what about that top 10% of outperformers? Historically, how have they performed on the upside? Below is another summary table showing how that select group of funds fared in the past on the upside: 

Though the average fund in this select group lost less than the market in 2008, historically as a group, they have not shown the ability to subsequently capture a meaningful portion of the market’s upside.  Comparing the longer term Downside to Upside Ratio shows there is very little added value. 

Perhaps most interesting, these comparisons show that the active managers that protected investors in this down market are not necessarily making brilliant investment decisions, but rather they have simply embraced lower risk strategies.

Though investors may be cheering their performance in bear markets, it is highly probable most are going to experience disappointing relative performance in subsequent bull markets.

The investment industry is full of individuals who claim to have the ability to make great stock picks (i.e., accurately assess mispricings in stock valuations and beat the market). Irrefutable evidence, however, shows that this is rarely accomplished, and when it is accomplished it cannot be attributed to skill anymore than luck.

It is therefore troubling that everyone from small retail investors to large institutional investors still widely embrace this hallmark of any active strategy. Virtually every portfolio we analyze for prospective clients holds some (in most cases many) individual stocks.

It sounds enticing when investment professionals try to sell us on their ability to pick winning stocks and beat the market, but such a strategy is extremely difficult in practice. I thought it might be helpful to demonstrate the futility of this strategy by highlighting the recent acquisition by Bank of America of Merrill Lynch.

In theory, such an acquisition is similar to stock picking: You identify your acquisition target via a screening process, scrub the financials, run it through a valuation model, compare it to the market price and make a decision.

In September 2008, Merrill Lynch’s balance sheet was so impaired from its bets on subprime mortgages that it appeared poised to suffer the same fate as Lehman Brothers – bankruptcy. Enter Bank of America, which sensed a “fantastic” opportunity (their words, not ours) to acquire one of the largest brokerage and investment banking companies in the world. The deal was set to close at year-end.

Even though the market was indicating its opinion that Merrill was worth far less than the purchase price Bank of America had agreed to, BoA proceeded ahead. As the deal prepared to close on December 31, 2008, hundreds of investment professionals from several leading investment banks and consulting firms spent thousands of combined man-hours poring through Merrill Lynch’s books. Ultimately, they valued the company at $29 per share, or $50 billion dollars. This was a significant premium to the market’s assessment of Merrill’s stock, which by that time was trading at $17. Both parties repeatedly assured investors their due diligence was solid. The deal closed on Jan. 1, 2009.

Prior to the announcement of the Merrill acquisition in September, Bank of America stock was valued above $30 per share. By mid-February, after the deal had been finalized, Bank of America reached a low of about $3 a share, down more than 90%. It was no coincidence that, by February, Bank of America stock was trading as though it had blown $50 billion of its shareholder’s equity. Obviously, the market did not agree with BoA’s $29 per share valuation of Merrill and took it, unmercifully, from its new owners for their error in judgment.

This should be a stark lesson to anyone who thinks they know more than the aggregate view of the market. If hundreds of well-educated, smart and well-trained individuals with unfettered access to critical information cannot come even reasonably close to a correct value for one of the most well-known firms in the world, we have to wonder why your average active manager should be able to find “hidden” values in such an efficient market.

As the data shows – and as Bank of America can attest – the pricing efficiency of the market is not a force to be trifled with.

I typically write on topics pertaining to portfolio construction and how embracing widely accepted investment theories such as Modern Portfolio Theory and Efficient Market Hypothesis can go a long way in protecting investors from needlessly assuming excessive risk. Given the current market environment, however, I feel compelled to touch on some basic principles outside of investment theory that can also go along way in helping you protect your wealth.

Given the high profile misdeeds recently of certain individuals in the investment industry like Bernie Madoff and Marcus Schrenker (who allegedly tried to fake his own death by jumping out of a plane), investors are rightfully anxious about making sure they are working with a trustworthy and reputable advisor. Thankfully there are a few simple rules of thumb all investors can follow that will greatly minimize their risk of being victimized by an unscrupulous con artist masquerading as an investment advisor.

First, there is the old adage, “If it’s too good to be true, it probably is.” This may seem like a cliché, but it certainly eluded those who invested billions of dollars with Bernie Madoff. The fact is that excess returns above T-bills are only generated by assuming risk. If someone offers you a great return with no risk, rest assured – intentionally or unintentionally – they are not sharing with you the whole picture.

Second, demand transparency. All too often financial mismanagement or fraud is committed by taking advantage of a client’s trust and keeping them in the dark. Demand to know exactly what you are paying; demand to receive monthly statements showing all transactions; demand to know what you are invested in and where it is being held; and, demand for this to come from a third party. You may hear many excuses why this may not be offered, but none supersedes your right to know how and where your money is being invested. If an advisor is not willing to meet this standard of transparency, walk away.

Third, make sure you are dealing with a qualified individual or team of individuals. Look for firms that have professionals with the CFA, CFP and/or CPA designations on staff. All three of these designations have very high professional and ethical standards that must be abided by, and because they are difficult to obtain they tend to work as a screening mechanism. To be clear, this does not imply you will have superior investment results, only that the individual has obtained a certain level of competency, something that should not be overlooked given the investment industry’s low barrier to entry.

In addition, credential inflation is very pervasive in the investment community. There are many meaningless designations that investment product providers create that look similar to the CFA, CFP or CPA designations, but that are actually merely “window dressing” intended to give their sales agents the appearance of credibility. Legitimate experience and achievement is not overrated and a lack of it should be questioned.

By no means is this a complete list, and following it does not guarantee you will have a flawless investment experience; however, it will help minimize the probability of your hard earned wealth being mismanaged. There are many competent and honest advisors out there, and with a little prudence and willingness to investigate, investors can easily find them.