With daily headlines about higher oil and food prices, inflation remains an inescapable topic. Inflation for the year ending June 2008 came in at 5 percent, and while this does not sound terribly high for those who remember the 1970s, it is painful for clients for two reasons. First, it is much higher than what they have experienced in recent memory, and second, the price increases of items they must buy every week - food and gas - have increased dramatically more than the 5 percent overall figure. Clients feel this inflation all the time.
For investors, there are many implications of inflation, but the most imperative is the erosion of their portfolios' purchasing power. As an advisor, there are three specific allocations to funds you may want to consider in an effort to provide some protection against high levels of inflation.
First, funds that invest primarily in Treasury Inflation-Protected Securities, or TIPS, provide a direct hedge against unexpected inflation. The value of these securities is linked to the change in the Consumer Price Index. As CPI rises, both the principal and coupon payment of these bonds increase. Of course there is the risk that, if CPI decreases, the value of the bonds will fall. Note that investors in TIPS must pay tax on this adjustment to principal even though it is not received until maturity; this is known as "phantom income." Mutual funds have an advantage over individual securities in this sector because they avoid the issue of "phantom income" by distributing the income so the client does not have to find another source of funds to pay the taxes.
Second, take a page from modern portfolio theory and look at funds that invest in securities linked to commodities. These can provide a portfolio with an allocation that has low correlation to the other investments, but have risk and return characteristics similar to those of large cap equities. When inflation is caused primarily by increases in the prices of commodities, a modest allocation to commodities provides diversification benefits that can improve the overall risk-return profile of the portfolio. Note that funds in this sector have achieved tremendous returns recently and are at risk of a pull-back if commodities prices fall.
However, there is also a chance that, by the time commodities inflation subsides and these funds retreat, other segments of clients' portfolios will have begun to recover. Funds in this sector typically invest in futures contracts or other derivatives and provide exposure to this asset class not easily available to retail investors through the purchase of individual securities. Note that derivatives are linked to the value of an underlying security, may be volatile and are subject to liquidity and counter-party risks.
Finally, on a less exotic note, short-term bonds may help clients' portfolios during a tough market characterized by high inflation. While short-term rates are low now as the Federal Reserve struggles with the conflict between growth and inflation, if inflation persists, eventually rates will increase. When rates increase, longer bonds typically fall in price more than short bonds, though short-term bonds are also subject to interest rate risks. A fund with shorter bonds typically will retain more of its value, the bonds will mature more quickly and the fund typically will be able to take advantage of reinvesting at the higher interest rates.
There is no guarantee that diversification will ensure against loss, and we don't know where inflation or the markets in general will go from here, but allocations to these types of investments will help portfolios weather the challenging environment.
Mike McManamna is a product specialist with Genworth Financial Securities Corp.