From the July 2009 issue of Research Magazine • Subscribe!

July 1, 2009

Inflation Proofing: How to Guard Against the Return of Rising Prices

In another break from business as usual, some advisors are reevaluating their buy-and-hold philosophy, or at least rebalancing more often.

With prices falling on everything from some food to plenty of real estate, your clients may have little interest in talking about ways to inflation-proof their portfolios. What's more, their desire for asset protection in the wake of the recession may also be pushing them toward portfolio moves that would be especially risky if inflation increases suddenly.

For example, James W. Coleman, founder of Coleman Financial Advisory Group in Waterbury, Conn., is encouraging clients to resist the urge to flee from equities. "Equity valuations will reflect an expanding economy more quickly than any other investment, and it won't take much to move the market up when the enormous amount of cash is teased off the sidelines," he says. "With potential returns taking place over very short time frames, investors can't afford to be totally out of stocks."

Coleman uses an ocean metaphor to illustrate the opportunity for clients. "Just as when the tide is receding, waves still hit the shore, we will see cyclical bull cycles in the secular bear market," he says.

Pitch Stocks

How can you convince clients to remain invested in equities to capitalize on those waves of opportunity? Point out that while rising inflation, like the recent spike in gas prices, can hurt profits in the short-term, because companies eventually can increase costs for consumers, inflation often has a neutral effect on stocks. So says Jeff Spitzmiller, CFA, chief investment officer of Iron Point Capital Management, a third-party money management firm based in Folsom, Calif. "Historically corporate profits have outpaced inflation," he explains. "Currently we think U.S. companies with sizeable overseas earnings or foreign companies are in the best position to succeed if inflation takes off."

Utility companies provide another alternative for equity-shy, cash-heavy investors, says Jeffrey A. Carbone, CFP, of Cornerstone Financial Partners, in Cornelius, N.C. "Utility companies are offering 6 percent to 8 percent on their dividends, a significant improvement over the banks' 1 percent to 2 percent in interest," he explains. "Clients are wary of equities, but because they are still turning on their lights and brewing the morning coffee, they appreciate that utility companies aren't going away."

To encourage clients to buy utilities now when prices are low, Carbone stresses the industry's traditional reliability and focuses on companies in his own backyard, thereby appealing to investors' psychological bias toward companies they are familiar with.

Be Cautious on Bonds

For clients still gravitating to bonds, Spitzmiller advises staying on the shorter duration end of Treasury securities, particularly as the deficit and supply of Treasury bonds increase. "In 2007, net issues of Treasury securities were $237.5 billion. In 2008, this figure was $1.239 trillion, and likely to continue moving higher going forward. This along with the potential drop in demand for these securities as foreign investors repatriate assets hurt the potential returns of Treasuries," he says. "Today, their low yields relative to historical levels also provide more downside than upside."

Of course, inflation worries can be addressed most directly with Treasury Inflation-Protected Securities (TIPS). While conventional Treasury bonds offer fixed semi-annual interest payments and a fixed principal payment at maturity, TIPS' principal values are linked to the Consumer Price Index (CPI) and adjusted every six months to reflect the effects of inflation. If the CPI inches up 2.5 percent over the course of the year, the principal value of a TIPS bond is adjusted upward by 2.5 percent and the fixed rate of interest is applied to the inflation-adjusted principal. You can invest clients in funds that specialize in TIPS or buy directly from the Treasury at www.treasurydirect.gov.

However, Carbone finds TIPS' current yield unattractive when compared to corporate bonds. "In addition to corporate bonds, we also hold a pretty good amount of international bonds, both as a hedge to inflation and a play on the U.S. dollar," he adds.

U.S. Treasury-issued I-Bonds also can offer inflation protection. With I-Bonds, the interest rate, not underlying principal, fluctuates along with prices. Interest from I-Bonds comes from two components, a fixed interest rate and a variable one. While the fixed rate is set at the time of purchase, the variable rate moves with the CPI. Notably, I-Bonds have some tax advantages over TIPS for investors in taxable accounts.

New Commodity Role

Conventional wisdom holds that gold and other commodities provide a useful hedge for inflation -- and there's plenty of current interest in gold- and silver-focused exchange-traded funds. After all, when inflation rears its head, the price of gold usually goes up. In the five highest-inflation years since World War II -- 1946, 1974, 1975, 1979 and 1980 -- the average real return on stocks, measured by the Dow, was minus 12.33 percent, compared to 130.4 percent for gold, according to metals dealer Blanchard & Co. But there are problems with relying on gold alone as a hedge to inflation. Specifically, from 1980 to 2001, prices in general doubled, but gold's price fell from $850 to $257.

Accordingly, many advisors take Carbone's position and view gold primarily as a portfolio diversifier that does not move in lockstep with stocks and bonds. To further diversify and hedge inflation, Carbone is beginning to take positions in real estate investment trusts (REITs), especially those in their infancy. "REITs in the capital-raising stage can take advantage of buying opportunities in the down market," he explains. "We're interested primarily in residential REITs that invest in student and senior housing as well as diversified REITs that combine industrial, residential, and office properties."

While clients' current REIT allocation ranges from 5 percent to 10 percent, Carbone says the percentage could get as high as 15 percent or 20 percent if inflation kicks in.

Says Spitzmiller: "While commodities in general are well off their highs from 2008, if inflationary pressures reemerge, commodities and other real assets could do well. A global uptick in spending will most assuredly bring about higher consumable commodity prices."

Adapt Your Philosophy

In another break from business as usual, some advisors are reevaluating their buy-and-hold philosophy, or at least rebalancing more often. Returning to the tide metaphor, Coleman says: "When you think about the tide receding in a secular bear market, you cannot afford to just plop your boat down on the beach and hope that the tide is going to come in and pick it up; chances are you're going to be stuck there. Just as managers need to be more active in today's market, looking for mutual funds that aren't too bloated and are nimble enough to trade and take gains as they present themselves makes sense."

With inflation on the horizon, Coleman also stresses the need to keep an eye on fund expenses and "evaluate real returns, not nominal returns -- after inflation and after taxes." With consumers hanging onto their wallets, inflation seems a distant worry. Yet, when investors on the sidelines regain their confidence, the market could recover quickly and deliver a swift blow to consumers' purchasing power for goods and services, as well as stocks. Accordingly, ensuring your clients participate fully in the market's eventual rise requires building in some inflation protection before they think they need it.

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Marie Swift is the president of Impact Communications, a marketing and communications firm for independent advisors; see www.impactcommunications.org.

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