TIPS aren't the only tool that investors can use to battle inflation over the long run.
Inflation is one of the most fundamental hurdles that any investor must attempt to clear. It's not entirely clear that inflation is in the cards, in the near future at least, but it has been on investors' minds. For example, when energy and foodstuff costs surged in mid-2008, many investors became understandably nervous.
More recently, inflation worries have been replaced by fears of extreme recession and even deflation. Looking further down the road, however, the federal government's attempts to jump-start economic growth could lead to protracted inflation. Thankfully, investors have an increasingly powerful tool kit to use against the corrosive impact of inflation on purchasing power.
Treasury Inflation-Protected Securities, which provide an explicit hedge against inflation as measured by the government's consumer price index, are the fixed-income world's traditional answer to the inflation problem. That's because TIPS bonds' face values are adjusted in line with CPI, providing principal protection and increased interest payments over time in an inflationary environment. At this time, many respected mutual fund managers think TIPS are attractively valued, particularly when compared with analogous maturity nominal Treasury issues, which are offering meager yields.
Top-flight offerings such as our Fund Analyst Picks Harbor Real Return HARRX and Vanguard Inflation-Protected Securities VIPSX are a good way to gain exposure to TIPS; however, inflation protection isn't solely limited to the TIPS asset class and can also come from other areas, such as equities, multisector approaches, and commodity exposure, as we highlight below.
Dreyfus Appreciation DGAGX
Several market commentators have argued that investing in equities, which have higher long-term expected total returns than fixed-income securities, is the best way to keep ahead of inflation. To that end, we think that large-blend offering Dreyfus Appreciation has served investors well both in inflationary periods and times of economic slowdown. That's because the fund's experienced management team focuses on purchasing the stock of dominant, high-quality companies with sustainable competitive advantages over rivals. Firms with dominant positions in their industries can exhibit greater degrees of pricing power, putting them in a better position to pass price increases through to end customers. Moreover, these very same characteristics can aid these firms in difficult economic times, as the advantages they hold over rivals often result in strong balance sheets and diversified revenue streams, which can mitigate economic trouble.PAGEBREAK
Fidelity Strategic Real Return FSRRX
This fund offers a different kind of approach to inflation protection. Lead manager Derek Young and a team of sector specialists divide the fund's assets between TIPS, floating-rate bank loans, commodity-linked notes, and real estate investment trusts, all of which have inflation-fighting properties. This fund's recent performance has been strong, partly due to the rally in bank loans, TIPS, and REITs, but in 2008 the fund suffered considerable pain as each of the asset classes in which it invests hit the skids at the same time. Over the long term, though, we think it is a compelling combination. Exposure to commodities can guard against price increases because of a global thirst for oil, metals, and agricultural products that has been partly driven by increased demand from emerging-markets countries. Moreover, while the fund's real estate segment particularly hurt last year, management invests in a fairly broad range of these equities that should provide good total return over time.
PIMCO Commodity RealReturn PCRDX
Finally, this fund offers a derivatives-based strategy that attempts to modestly beat the Dow Jones-AIG Commodity Index, a benchmark that provides exposure to a wide range of commodities, such as crude oil, wheat, gold, coffee, and more than a dozen others. Because commodities tend to display negative correlations to equity and bond returns, but a positive correlation to inflation, these assets have long been thought a good hedge against rising prices. Moreover, PIMCO's strategy using structured notes for commodity exposure allows it to overlay a portfolio of TIPS on top of its commodity exposure, providing a secondary measure of inflation protection.
It's important for investors to purchase inflation-fighting securities when they're undervalued, and the fear of inflation is discounted, rather than when everyone is attempting to pile into them. For instance, a nominal 10-Year Treasury bond is currently yielding 2.95%, while a comparable maturity TIPS issue yields 1.44%, suggesting that the market assumes a roughly 1.5% inflation rate over the next decade. And while this eventuality isn't impossible, many TIPS managers we speak to argue that it presents a dramatic understatement to the level of inflation we're likely to experience given governmental attempts to stimulate the economy, or even a return to recent trend inflation levels (in the 2.5% to 3.5% range). Thus, we think a long-term allocation to a TIPS fund, supplemented by one of the options discussed above, can mitigate a portfolio's exposure to the corrosive effects of inflation and improve overall portfolio results.
Lawrence Jones is associate director of fund analysis for Morningstar.
This article originally appeared in Morningstar FundInvestor.