Funds for Inflation Protection

05/01/2014 9:00 am EST

Focus: FUNDS

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Despite low reported rates of inflation, many investors continue to ask us what to do to prepare in case it increases. Below, we examine how various types of assets have performed during periods of strongly rising prices, explains Mark Salzinger, editor of No-Load Fund Investor.

First, it’s important to point out that inflation has been very mild in the US since the early 1990s. In fact, the last period of truly serious inflation was from 1973 through 1982.

In a recent Equity Strategy report from Citigroup Global Markets, Chief US Equity Strategist Tobias Levkovich included a table showing the correlations of the ten sectors of the US equity market with year-over-year changes in the CPI.

According to this data, the sectors that showed the strongest correlations were energy, which makes sense, and electric utilities, which doesn’t (because energy is a cost for them), followed by consumer staples and industrials.

The period 1973 through 1982, however, is more revealing. During this 10-year period, when inflation averaged 8.7% per year, the S&P 500 (SPX) gained only 6.7% annually. In other words, the stock index trailed inflation by two percentage points per year.

Meanwhile, investment-grade bonds also trailed inflation by various percentages, depending on the maturity, while Treasury bills nearly kept pace. (So, from among stocks, bonds, and T-bills, T-bills were the best performers during the period.)

However, commodities and real estate performed a lot better. From the beginning of 1974 through 1982, the Goldman Sachs Commodity Index more than doubled. Gold went up between two and three times.

The period’s biggest winner may have been REITs, a very small industry at the time. The level of the FTSE NAREIT Equity REIT index went up by more than five times.

Investors who want broad, energy-heavy commodities' exposure in expectation of higher inflation may want to consider the iShares S&P GSCI Commodity-Indexed Trust (GSG).

Those who want a little gold could go with the most liquid gold bullion ETF, SPDR Gold Trust (GLD), or with iShares Gold Trust (IAU), which has a lower expense ratio (0.25%, versus 0.40%), but a slightly larger bid/ask spread.

Conventional fund investors who want exposure to equity REITs have many options. For the broadest, simplest exposure, we would recommend Vanguard REIT Index (US:VGSIX). Besides its broad portfolio (132 holdings), this fund offers the benefit of ultra-low expenses.

Floating rate and Treasury Inflation Protected Securities (TIPS) funds weren’t around in the 1970s and 1980s, but, by design, should outperform during inflationary periods.

Floating rate bonds pay interest that adjusts higher or lower with very short-term interest rates, which tend to move with inflation. As a result, they have little interest rate risk, though they do have credit risk.

Two favorites of this kind are Fidelity Floating Rate High Income (US:FFRHX) and Price Floating Rate (US:PRFRX). The interest and principal payments of TIPS adjust upward with increases in the CPI. Because they are Treasury securities, they have no conventional credit risk.

However, they do have interest rate risk, and would suffer, relative to conventional Treasuries, if inflation turned out to be lower than investors expected.

Here again, interested investors may as well go with funds from Vanguard, which offers Inflation-Protected Securities (US:VIPSX) and Short-Term Inflation-Protected Securities (US:VTIPX). The latter has less interest rate risk than its sibling, but also a lower yield.

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