Our Picks for Inflation Protection

Investors saving for retirement or other long-term goals ignore inflation at their peril, as I discussed in a recent article. By the time you start tapping your portfolio to meet your income needs, those dollars you've managed to save could be worth a lot less than they are right now, and they are likely depreciate further over the course of your retirement years.

That's why it's so important to ensure that your portfolio is adequately protected against inflation. Some inflation-fighting vehicles have explicit protection against rising prices, such as Treasury Inflation-Protected Securities. Others, such as stocks, protect against inflation indirectly.

Here's an overview of the key vehicles with inflation-fighting attributes as well as some of Morningstar's top picks within those groups.

Inflation-Protected Bonds
The Thesis
For holders of nominal (that is, not inflation-protected) bonds, inflation is a natural enemy, right up there with rising interest rates. If an investment is delivering a fixed payout, inflation will reduce the value of that payout accordingly. That's where inflation-protected bonds come into play. There are two main varieties: I-Bonds and inflation-protected bonds. The former are bonds for individual investors issued by the Treasury Department; their yields adjust upward to reflect changes in the Consumer Price Index. (This article provides more color on I-Bonds.) Inflation-protected bonds, such as TIPS, are similar, but the inflation adjustment comes at the principal level, not in the bond's yield.

Best Bets
There are no funds composed of I-Bonds, but there are a number of offerings that focus on inflation-protected bonds. For plain-vanilla TIPS exposure, it's tough to beat the low-cost  Vanguard Inflation-Protected Securities (VIPSX); for exchange-traded fund enthusiasts,  iShares Barclays TIPS Bond (TIP) is another low-cost, no-nonsense choice. The PIMCO-managed  Harbor Real Return , meanwhile, has successfully employed a broader toolkit that encompasses non-U.S. inflation-protected bonds and the use of forward contracts to obtain TIPS exposure. While  SPDR DB International Government Inflation-Protected Bond (WIP) isn't an official  ETF Analyst Pick, it provides both inflation protection and diversification away from the U.S. dollar. Bear in mind, however, that when articles about inflation are splashed across every newspaper and financial website, TIPS can get expensive, and that could be the case right now, too. (For a little color on this issue, check out this article.) Given that TIPS would also be susceptible in a rising-rate environment, anyone building a position in them right now should tiptoe during a period of months rather than adding to their holdings right now.

Bank Loans
The Thesis
Unlike inflation-protected bonds, bank loans don't include an explicit mechanism to ward against inflation. But they stand to be fairly hardy when inflation is on the move. That's because bank-loan payouts fluctuate in line with the London Interbank Offered Rate--the rate that banks charge one another to borrow money. When the LIBOR heads up, which is often the case during inflationary environments, so do bank-loan coupon payments.

Best Bets
Bank-loan funds might seem to have everything you need for the current economic environment: imperviousness to rising interest rates plus some inflation-fighting characteristics. But investors should tread with caution in this varied category. Due to credit sensitivity and forced bank-loan selling from institutional investors, the average bank-loan fund lost a shocking 29% in 2008. One of Morningstar's favorite funds here is one of the group's slow and steady options,  Fidelity Floating Rate High Income (FFRHX), where manager Christine McConnell assiduously avoids the market's riskiest loans. As with TIPS, think about dribbling money slowly into this category during a period of a few months rather than moving it in all at once. 

Commodities/Metals Funds
The Thesis
The premise behind owning commodities investments for inflation protection is straightforward: If the prices of goods are going up, an investment that captures price changes in food, energy, and basic-materials costs will thrive at the same time.

Best Bets
Although the case for commodities for inflation protection is straightforward, the implementation isn't. Owning the stocks of commodities companies, as with an offering like  T. Rowe Price New Era (PRNEX), provides indirect exposure to the prices of stuff. And while commodities futures-based funds aim to provide broad, and direct, exposure to the prices of goods, in practice they haven't been perfect trackers of commodity prices as a result of a situation called contango. (Read this article for a discussion of the pros and cons of these investments.) The PIMCO-managed  Harbor Commodity Real Return  is Morningstar's sole  open-end Fund Analyst Pick within the commodities category. Our exchange-traded fund team, meanwhile, has  a few commodities picks, including  iPath DJ-UBS Commodity Index (DJP).

Stocks
The Thesis
Stocks are another indirect way to gird your portfolio against the threat of inflation. Their returns are variable, in contrast with fixed-rate investments, giving them the potential for higher returns than bonds. That means that inflation could take a smaller bite, in percentage terms, out of your future purchasing power.

Best Bets
Not all stocks will thrive in an inflationary environment, and some companies may even see their profitability flag. To help identify companies with a strong history of profitability through a variety of economic environments, screening for firms with high returns on equity is a good starting point. Morningstar's preset  Wealth Creators screen can help you identify such firms, and layering on an additional screen for wide moats will further winnow down the universe to companies with long-term competitive advantages. Fund investors have a few top options, including  Vanguard Dividend Growth (VDIGX) and  T. Rowe Price Dividend Growth (PRDGX) (traditional actively managed funds) and the index fund Vanguard Dividend Appreciation (available as a conventional  mutual fund  and  ETF (VIG)). 

A version of this article appeared Feb. 21, 2011.

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