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By Jason Stipp | 07-15-2011 09:26 AM

Using Alternatives to Fight Inflation

ETF analyst Tim Strauts explains how fixed-income alternatives could buffer your portfolio in a rising rate environment, or offer more equitylike exposure with less volatility.

Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar.com's Inflation Report, today we're checking in on how you might employ alternative strategies to keep ahead of inflation.

Joining me with some ideas about those strategies and some funds for further consideration is Tim Strauts. He is an ETF analyst with Morningstar. Thanks for being here, Tim.

Timothy Strauts: Glad to be here.

Stipp: So the first question for you: A lot of investors when they think about inflation, the thing that worries them the most is the fixed-income portion of their portfolio. What are some of your ideas about the tools investors could implement to help protect their fixed-income portion from the effects of inflation?

Strauts: When people talk about inflation, I think they really mean is, what's the effect of rising interest rates in my portfolio? So obviously that's going to be negative for your fixed-income portfolio.

So two alternative strategies could be: one is merger arbitrage, and merger arbitrage is basically trying to take advantage of, after merger deals are announced, the spread that's available on stocks.

So, for example, if Google announces they're going to buy out a smaller firm, they may announce that they're going to buy out the firm for $40 a share. Until that merger is completed, the stock price--you don't get your $40 a share. So the stock price will probably rise to somewhere around say, $39.50. On a merger arbitrage strategy you can buy the stock for $39.50 and wait until you get your $40, so you can cut that $0.50 premium. And you do that over many, many mergers to diversify your portfolio. So it's a way to get a little extra return out of these spreads.

Stipp: So that little bit that doesn't go all the way to $40, that's just in case for some reason the merger doesn't go through, right? There is a little bit of discount due to the uncertainty there.

Strauts: Yes. That's the risk is that Google has antitrust issues and can't get the deal through, and then the [addition target's] stock is going to fall back down, so that's what you pay for the risk.

Now if you spread that risk along 50 different mergers or 100 different mergers, it's not that much risk, and the returns you get on merger arbitrage are similar to fixed income, and actually the spread, the size of that spread is related to short-term interest rates. So if we're in a rising interest rate environment, the spread should be wider, meaning you can make more profits in merger arbitrage.

So the two funds we like in that category in the mutual fund space is Merger MERFX, and in the ETF space it'd be Credit Suisse Merger Arbitrage ETN and the ticker is CSMA.

Now the other category we also look at is market neutral. Now market neutral is the idea that you want to eliminate the market effects from your portfolio. So what a typical strategy will do is go 100% long in stocks and 100% short in stocks, so you're net zero exposure to the market, and the returns there are just that year longs do better than your shorts. Again, the returns can be similar to fixed income and really a good diversifier there.

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