Investors who want to protect their portfolio against rising prices can spend a long time debating the most effective inflation-fighting tools. Many opt for inflation-linked bonds, while others go for commodities, real estate or stocks. But the best answer may be "all of the above."
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That's the consensus among many money managers who are now tossing everything but the kitchen sink into funds designed to combat inflation. Consider the Neuberger Berman Dynamic Real Return Fund, launched late last year: It can invest in commodities, global inflation-linked bonds, high-yield bonds, bank loans, U.S. and emerging-markets stocks, master limited partnerships, and real estate.
More than 20 such multi-asset-class inflation-fighting funds have been launched since the start of 2010, according to investment-research firm Morningstar. "We put together a diversified portfolio to offset market risk. Should we not do the same to offset inflation risk?" asks Joanna Bewick, lead manager of the Fidelity Strategic Real Return Fund (symbol FSRRX), whose more than seven-year track record makes it one of the older multi-asset-class funds designed to combat inflation.
While December's 1.7% inflation hardly inspires 1970s flashbacks, investors should consider grabbing all the tools within reach to fortify their portfolios. Even low levels of inflation can have insidious effects on investments. Although we remember the 2000s as a time of benign inflation, for example, you needed $1.25 in 2009 to have the same buying power as $1.00 in 2000. Erosion of purchasing power is a particular concern for seniors, who generally live on a fixed income and spend more money on health care, where prices are rising much faster than overall inflation.
What's more, the Federal Reserve's bond-buying spree has sparked inflation jitters among many analysts. In late January, the Fed said it would continue to buy Treasury and agency mortgage-backed securities at a pace of $85 billion per month. With central banks in other developed markets making similar moves, "that has the potential to ignite" inflation, says Andrew Johnson, head of investment-grade fixed income at Neuberger Berman.
The broadly diversified funds may appeal to investors who want inflation protection but don't want to juggle commodity, real estate and other volatile niche holdings. The new funds' grab-bag approach is gaining steam as some of the most popular stand-alone inflation-fighting tools appear increasingly risky. Many investors, for example, buy Treasury inflation-protected securities and assume that their inflation-fighting work is done. The principal of these bonds is adjusted to keep pace with the consumer price index.
But TIPS with maturities of up to ten years are currently offering negative real (inflation-adjusted) yields. And rising interest rates, which cause bond prices to fall, can do a lot of damage to TIPS. "I do caution investors from using TIPS as a pure inflation hedge, because the prices have the potential to be very volatile as interest rates increase—regardless of what happens to inflation," says Brian Rehling, chief fixed income strategist at Wells Fargo Advisors. While a modest TIPS allocation still makes sense as part of a diversified portfolio, Rehling says, "they are a little bit more difficult to use than investors realize."
Many investors also think of gold as a stand-alone defense against inflation. But the metal actually has a very mediocre track record against the CPI. Fidelity studied the performance of various asset classes against the CPI over rolling 12-month periods between December 1973 and the end of last year, and it found that gold beat inflation in only 54% of those periods—compared with a 71% success rate for Standard & Poor's 500-stock index and 75% for the Barclays U.S. Aggregate Bond index. When it comes to fighting inflation, gold is "a coin toss," Bewick says.
A Potpourri of Inflation-Fighting Tools
Such research helped Fidelity arrive at its baseline asset allocation for the Strategic Real Return Fund: 30% TIPS, 25% floating-rate loans, 25% commodity-linked notes, and 20% real estate investment trusts and other real estate holdings. While each of those asset classes can be a decent inflation hedge, Bewick says, "none of them is perfect, and not one of them is nearly as good as the combination," which taken together has an 85% success rate against the CPI. The managers can make modest adjustments to that basic allocation based on valuations and macroeconomic trends. Bewick says she's currently overweighting REITs and floating-rate debt and underweighting TIPS and commodities.
Other managers seek to spread their bets evenly among inflation-fighting asset classes. In the Neuberger Berman Dynamic Real Return Fund (NDRAX; class A shares have a 5.75% load), each asset class makes a roughly equal contribution to the portfolio's overall inflation sensitivity. The approach should reduce risk without sacrificing performance, Johnson says, so "you're likely to generate decent returns while you wait for inflation to occur."
Other recent entrants include Principal Diversified Real Asset (PRDAX; class A shares have a 3.75% load), launched in 2010, and Pimco Inflation Response Multi-Asset (PDRMX), introduced in 2011.
For older investors with bond-heavy portfolios, the multi-asset-class funds not only help protect against inflation but also help diversify holdings and lower risk. Over the past ten years, for example, the Fidelity Strategic Real Return fund has had a 0.29 correlation with the Barclays Aggregate Bond index—meaning the fund tends to zig when bonds zag.
The new multi-asset-class inflation-hedging funds have yet to withstand a period of serious inflation. And because the funds are juggling so many asset classes, it may be tough for investors to gauge the success of the strategies. But Morningstar in January launched a new index that may serve as a benchmark for these funds. The Morningstar U.S. Real Asset Index consists of 40% TIPS, 30% commodity futures, 15% REITs and 15% commodity stocks.
In testing how the index would have performed between January 1980 and November 2012, Morningstar found its risk comparable to the Barclays U.S. Aggregate Bond Index, and its annual returns beat the S&P 500. Blending a traditional stock, bond and cash portfolio with even a 10% or 20% allocation to the index would have reduced risk and boosted inflation-adjusted returns over that period, Morningstar found. While it's tough to say whether such trends will continue in the future, says Morningstar Indexes senior vice-president Sanjay Arya, it's clear that "when you're trying to hedge inflation you can't fight it with one single asset class."
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