Lingering Low Rates

The Fed has kept the Federal Funds Rate, the interest rate at which institutions with funds deposited at the fed can borrow and lend balances to and from each other overnight, at right above 0% since the recent recession. This year, Janet Yellen announced that the Fed would end quantitative easing, an economic policy putting downward pressure on the cost of capital. Yellen concordantly intimated that the Fed was on course to raise the Federal Funds Rate in 2015; this would make money more expensive and cause interest rates to increase. There is concern among academics and at the Fed about the direction of the economy and that raising interest rates could derail the recovery from the recession.

There is doubt that there will be interest rate increases anytime soon, as the precipitate of anemic economies across the globe limits growth in the U.S. On Wednesday, the President of the Fed in Minnesota proposed that the Federal Reserve Open Market Committee would not raise interest rates in 2015. Instead, he expects that the economy will be less than calm in the coming years, and inflation will not increase until 2018; in this case, the threat of increased inflation would not catalyze an increase in interest rates.

Two of the phenomena that some believe belie the stability of the US economy are the economic stagnation in Europe and the slowdown of GDP growth in China. They are thought to have the capacity to hinder global economic growth, as well as limit the likelihood that the U.S. economy will experience consistent growth in the coming years. France and Germany only is only narrowly escaping entering into economic recession in the third quarter of 2014. Meanwhile, the Communist Party in China is worried about waning GDP growth and is considering an economic agenda to free capital flows, in addition to liberalizing other sectors of the economy. If these are the circumstances and these events catalyze an economic reversal in the US, then interest rates will not be as likely to budge in 2015.

The strength of the U.S. economy and the effects of quantitative easing are, however, underestimated by those feeling uneasy about the Fed raising interest rates. Considering these two circumstances, we should see interest rates increase in the short-term. There is clearly controversy about the economy’s current direction. But we may be comforted by the fact that, to date, the US economy has experienced exceptional growth in 2014, excluding the first few months of the year. Given the strength the economic growth, it would seem that the Fed would raise rates to compensate for the above-average growth.

In addition, and perhaps more importantly, the effects of quantitative easing have the potential to put upward pressure on the interest rates. Indeed, the Fed flushed the economy with cheap capital, which will eventually result in rising inflation and, consequently, interest rates as the economy expands. Consumption will inevitably continue to increase as confidence in the economy escalates. Quantitative easing ensured an eventually increase in inflation, and the Fed will fail to inhibit inflation without raising interest rates.

The U.S. third quarter GDP grew by 3.5%, and the unemployment rate fell below 6.0% in September. There has been a consistent critical mass of signals for the Fed to start a contractionary monetary policy. In this economic environment, enough pressure has been built to warrant worry about increased inflation. It is not a question of if inflation will increase, but when. The Fed understands it will need to raise the Federal Funds Rate in the near future. Low rates will not linger much longer.

Property Types and Inflation

Multi Family

Of the five property types, multifamily is the second best hedge against inflation. Existing studies show that annual total returns from multifamily properties will increase by 1.09 for every unit increase in expected inflation and 1.19 for unexpected inflation (Huang and Hudson-Wilson 2007).
Note that an effective hedge against inflation will create a one-to-one relationship between inflation and returns.

Office

Of the five property types, office is the best hedge against inflation. Existing studies demonstrate that office properties respond positively to expected and unexpected inflation. That is, returns from office properties increase by 1.47 for every unit increase of expected inflation and 1.48 for unexpected inflation (Huang and Hudson-Wilson 2007). We may expect that if the inflation rate increases, we should see increased returns from office properties.

Retail

Of the five property types, retail has been shown to be the either be one of the best hedges or the worst hedge against inflation depending on if the studies surveyed retail properties with leases that included percentage of sales. Some studies show that there is even reason to believe that there might be a negative relationship between inflation and retail returns (Huang and Hudson-Wilson 2007). Others, however, have shown retail to be a strong hedge against inflation, albeit that they gather data outside the US (Sing and Low 2000). The latter might be persuaded by the assumption that investors may prefer retail as a hedge against inflation, due the long-term leases of the retail sector – often tied to sales – and the fact that expenses are often passed-down to tenants. We may conclude that expectations for retail returns are dependent on the stipulations included in the leases.
Note that may think it preferable to benefit from the flexibility of short-term leases if there is uncertainty about near-term levels of inflation and the economic environment is one in which there may be significant unexpected inflation. If there is limited unexpected inflation, we may prefer to stick to long-term leases.

Alternative vs. Traditional Investments

Once thought exclusive to risk-tolerant investors, the group of assets that have been called “alternative” investments is receiving the attention of more traditional investors. The endowments of select institutions have seen success by altering their investment strategies to include “alternative” investments in their portfolio. As the more traditional investors begin to notice the benefits of altering their investment strategies, it is more important than ever to compare the performance of alternative and traditional investments, and to understand how alternative investments can become part of one’s portfolio.
What is an alternative investment?
Types of Alternatives

• Private Equity
• Hedge Funds
• Managed Futures
• Alternative Mutual Funds
• Real Estate
• Commodities
• Infrastructure

Alternative investments use different strategies than the other investment types; these may include:

• Absolute rather than relative performance objectives
• The use of leverage instead of the use of limited or no leverage
• Usually being less liquid than the other types of investments, which offer daily liquidity
• Requiring often higher fees than the other investment types

Consequently, the performance of these investments is only moderately correlated to market indices. By comparison, the performance of the traditional types of investments is highly correlated to market indices.
Correlation Coefficient for Equities and Alternatives: 0.73
Correlation Coefficient for Fixed-Income and Alternatives: -0.09

How does the performance of alternative investments compare to traditional investments, such as equities and fixed-income investments?
Figure 1 shows the comparison of returns from traditional and non-traditional investments. Although there is generally less risk associated with investing in traditional investments, the graph clearly demonstrates that the non-traditional investments have the potential for greater returns; additionally, alternative investments outperformed traditional investments during crises.

 
Figure 1: Alternative vs. Traditional Investment Returns

How have endowments included alternative investments in their portfolios?
Despite the potential risks of certain alternative investments, there can be clear benefits associated with investing in alternative investments. An investor might choose to include these types of investments to improve the performance of his portfolio. Diversifying by including alternative investments may actually reduce volatility, and improve the risk-return characteristics of a portfolio.

The Endowment Model (aka the Yale Model):

Over the last quarter century, certain large endowments, such as Harvard and Yale, have restructured their portfolios. They have invested more in “alternative” assets, and less in long-only public equity and long-only public fixed income. Consequently, their portfolios have experienced strong returns. They have even outperformed portfolios invested more conservatively in “traditional” assets.