FUND WATCH


3 Funds That Fight Inflation

Elizabeth Ody

These funds invest in a blend of asset classes with an aim of delivering good after-inflation returns.



"What inflation?" might be your first response to the headline of this article. Maybe you've seen the most recent consumer price index figures, which show that prices declined by 2.1% over the 12 months (through the end of July). Or maybe you've just noticed the markdowns at shopping centers and widespread pay cuts that spell deflation, not inflation.

But the argument that easy money and enormous budget deficits will lead to a surge in inflation hasn't changed, even if the timeline for when it will set in is hazy. Even Warren Buffett has taken to trumpeting the need for vigilance on the purchasing power of the dollar -- noting in recent television appearances that he believes the coming inflation could be as severe as it was in the late 1970s, when the rate hit double digits.

The following three funds should be able to post fine returns even if inflation remains at bay for the next couple of years. And because each fund invests in an idiosyncratic blend of assets, a small stake in one of these funds could offer a conventional stock-and-bond portfolio some much-needed diversification.

Fidelity Strategic Real Return (symbol FSRRX) is built around four inflation-tackling asset classes: Treasury inflation-protected securities, floating-rate loans, commodities and real estate. Teams of specialists manage the TIPS, loan and real estate portions of the portfolio, while the fund's commodity exposure tracks the Dow Jones-UBS Commodity index. The index's heaviest weightings recently, from greatest to least, were oil, copper and gold.

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TIPS, which are Treasury bonds that adjust the value of their principal and interest payments in response to changes in the CPI, typically account for 30% of the fund's assets. The real estate portion of the portfolio, typically 20% of assets, holds a blend of the stocks and debt of real estate investment trusts and companies, such as hotel chains, that own significant amounts of property.

Chris Sharpe, who worked on developing the fund and joined as a co-manager last June, says the TIPS, commodity and real estate sides of the portfolio are intended merely to keep pace with inflation. The fund's holdings in floating-rate notes, which are typically made by banks to companies with below-average credit ratings, should generate most of the fund's after-inflation returns.

Interest rates on these loans reset periodically, usually every three to six months, to "float" a few percentage points above a short-term benchmark rate. This means that in an inflationary environment, which would almost certainly be marked by rising interest rates, these loans won't get killed along with the rest of the bond market (bond prices generally move inversely with interest rates). Because borrowers tend to be junk-rated, investors gain a few extra points of yield to compensate for the risk of default, which grows in a shaky economy. But the Fidelity team restricts its bets to "first lien" loans, or those with the most senior claim on a company's assets.

Don't be turned off by lackluster returns so far. The fund is flat since its inception in September 2005 through September 11. That is more a reflection of the bear market's brutal treatment of commodities, real estate and floating-rate loans than it is of any failings on management's part. The fund charges 0.73% in annual expenses and yields 2.8%.

Just as a kooky allocation has punished the Fidelity fund, an equally kooky asset mix has worked wonders for Permanent Portfolio (PRPFX). At all times, through all markets, this fund allocates 35% of its assets to U.S. Treasuries, 20% to gold, 15% to real estate and natural resources, 15% to aggressive-growth stocks, 10% to the Swiss franc, and 5% to silver. That simple approach generated annualized returns of 9.6% over the past ten years, trouncing both the Barclays Aggregate bond index's 6.3% annualized gain and Standard & Poor's 500-stock index's 0.8% annualized loss.

The fund's muse, the late investor and author Harry Browne, advocated a portfolio of an even mix of U.S. stocks, Treasuries, cash and gold. The allocations have been tweaked, but the premise of holding something for every type of economy remains: stocks for periods of economic expansion, real estate and gold for inflation, and Treasuries for deflation. "We don't believe anyone can accurately predict the future, so we've structured a portfolio that offers comprehensive diversification and loss protection for all markets," says manager Michael Cuggino.

In an inflationary scenario, all slices, save the hefty stake in Treasuries, should benefit. Rising interest rates will hurt that slice, but if the fund's allocation works as intended, the rest of the portfolio should more than compensate. The fund charges 0.84% in annual expenses.

It's tougher to get your head around Pimco All Asset (PASDX), a fund of funds with no static asset allocation to point to. Rob Arnott, chairman of Research Affiliates, which manages the fund, runs models to determine what Pimco funds to invest in and with what allocations.

Arnott's goal is both to beat an index of TIPS and to produce average annual returns of at least the rate of inflation (as measured by the CPI) plus five percentage points. Because of that focus, Arnott says, it's not unusual for him to hold a large allocation to TIPS, commodities and real estate funds. But the fund's prospectus allows him to stash as much as 50% of its assets in Pimco's U.S. and international stock funds (which are tied to indexes, although they are not pure index funds).

Performance has been solid, if not spectacular. Since the fund's inception in 2003, the D shares have returned 6.2% annualized, beating the Barclays TIPS index's 5.5% gain. But Arnott is trailing his CPI-plus-five goal by one percentage point per year through the end of June, the most recent month for which that comparative data is available.

Arnott doesn't hesitate to express his concerns about inflation. "You're seeing governments all over the world setting trillion-dollar bonfires every few months," he says. "Our models are predicting that inflation is likely to start sooner and hit harder than the market expects." At the end of June, 23% of assets were invested in pure TIPS funds, with the next-biggest stakes in Pimco's investment-grade corporate-bond fund and commodity fund (which is a member of the Kiplinger 25). The fund's D shares are available without a load through most discount brokers, although they charge a hefty 1.45% expense ratio. The D-shares yield 3.3%.



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