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By Greg Brown | 06-24-2010 12:55 PM

Can TIPS Fully Mitigate Inflation?

TIPS are a good, low-risk way to hedge against inflation, but the CPI measure they are based on is less than perfect, says Research Affiliates' Rob Arnott.

Greg Brown: Hi. I am Greg Brown, mutual fund analyst here at Morningstar. I am here today with Rob Arnott. Thanks for joining me today, Rob.

Robert Arnott: Thanks a lot.

Brown: In this time, you know, investors are very nervous about inflation, inflation in the near term and inflation coming up. And I am curious to know if – what you think about TIPS. Do TIPS – can they fully mitigate inflation? And is the CPI index a good indicator for inflation?

Arnott: The really short answer is no and no. The longer answer is TIPS, inflation-indexed government bonds are a very good way to hedge against inflation and are the natural asset of choice for a low-risk inflation hedge.

The problems with TIPS primarily center on the calculation of CPI. The government has a strong incentive to calculate CPI in a fashion that understates inflation. Why? Because it will have a bearing on the cost of servicing TIPS debt and much more importantly, on the cost of Social Security.

Brown: And how in your funds do you address the inflation concern?

Arnott: Taking a big picture portfolio view, most investors have the lion's share of their money in mainstream stocks and bonds. Mainstream bonds are brilliant in a disinflationary economic contraction. Mainstream stocks are brilliant in a disinflationary economic expansion. Both of them fall down in a reflationary environment.

So while most investors have two core portfolios, stocks and bonds diversified in whatever ways they chose. I think most investors need three. They need an allocation to equities to participate in economic growth. They need an allocation to bonds to tamp down the volatility and provide a reliable income stream.

And they need an allocation to a third bucket to protect against inflation and to gain diversifying exposure to alternative markets. That's missing in most investors' portfolios. It's non-existent for many, and it's small to middling allocation even for those who are avid adopters of the idea. So from an inflation perspective, our inflation toolkit is surprisingly broad.

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