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How Can I Protect My Portfolio From the Inflation Boogeyman?

Christine Benz

Morningstar director of personal finance Christine Benz moderated the following panel session at the 2012 Morningstar ETF Invest Conference. 

Christine Benz: I'm really happy to have such a terrific panel of experts here today to help us tackle this important question.

I've got Mark Carlson here on my immediate left. Mark is from Northern Trust where he is a senior vice president and fixed-income strategist in the exchange-traded funds group. At Northern, Mark is responsible for developing strategies for the firm's FlexShares products, including the FlexShares iBoxx Targeted Duration TIPS ETFs.

Chris Goolgasian is also here in the middle. Chris is from State Street Global Advisors where he is head of the U.S. portfolio management--investment solutions group. He is responsible for developing and implementing tactical and strategic multi-asset-class solutions for institutional clients, one of which is SPDR SSgA Multi-Asset Real Return ETF.

Last but not least, Axel Merk is here on my far right. Axel is the president and chief investment officer of Merk Investments, and he also manages the Merk Funds, including the Merk Hard, Asian, and Absolute Return Currency funds as well as the Merk Currency Enhanced U.S. Equity fund.

So, I'd like to start with a little bit of a panel discussion, and then we will segue into audience questions in the second half of the session. But I'd like to start with some stage-setting here, and I'd like to talk about the specter of inflation from each of the panelists' perspectives. How big a threat do you think inflation is in the near and in the long term? Mark, let's start with you.

Mark Carlson: Well, the conditions have been set for potential inflation given the amount of liquidity that the Federal Reserve has pumped into the market, not just QE3, but dating back to the originations of the financial crisis to the point now where we have roughly $1.6 trillion of excess bank reserves sitting on the Fed's balance sheet just waiting to be unleashed into the marketplace--an unprecedented level of reserves.

So, the mixture is there, but yet expectations are still fairly well-constrained. One of the important measures I look at is five-year, five-year forward break-even index. It's been trending higher for the last 12 months. However, it's averaging up almost close to 3% right now, so longer-term inflation is being raised as a concern, but relatively speaking it's still fairly well within reasonable expectations. As long as expectations remain under control, the Fed has the leeway to continue its aggressive monetary policy, but it could quickly turn both in the short term and then obviously becomes a longer-term problem.

Benz: Chris, how about you?

Christopher Goolgasian: Sure. So I think there is a line from literature that has a lot of good play today relative to the inflation world, and it's from Hemingway. There is one character in the book who says to the other, "How did you go bankrupt?," and the other one says, "Two ways: gradually then suddenly."

And to me that's the inflation world. If you're buying 1% bonds in a 2% inflation world, that is how you are not going to go bankrupt, but that's how you're going to lose real wealth gradually, and then suddenly you're going to wake up to $10 a gallon milk and say how did that happen? When did this creep up on me? And so to your question, Christine, I don't think the danger of rampant inflation is today, but the danger is in the future. And what you need to do from a client and portfolio perspective is consider buying some insurance for that future, buying some insurance for the chance that the central bankers don't get it right. The central bankers have conjured up $9 trillion in money out of thin air. There's a chance that they may not exit this correctly, and real assets can give you some insurance for that chance.

Benz: Axel, you recently wrote a commentary where you were pretty harsh about the Fed's recent actions, and you say that they are forsaking one of their mandates at the expense of the other. So they are looking at inflation and not focusing on that so much as they are on stoking employment.

Axel Merk: Sure, and let me give you here a couple of inputs on this. First of all, if one looks at a classic measure like five-year, five-year forward inflation, that has broken out of its 2 standard deviation bend on the announcement of QE3. So it's not just some fear mongers, but it is truly that the market thinks that, "Oh my God, QE3 might be inflationary."

And just to keep you thinking, it isn't so much on whether we are right that there will be inflation. I'm much more in this camp saying there is a risk that there will be inflation, and if you think there's a risk, if you think there is a risk that Fed is not going to get it right, then maybe you want to do something. Maybe you even have a fiduciary duty for your clients to do something about it.

Now, specifically on the Fed, what the Fed has done is they've cut the cord between the link of monetary policy and inflation, focusing more clearly on unemployment and the Federal Open Market Committee minutes that were released Oct. 4 re-emphasize that. They talk about, "Oh, let's get away from this calendar-date business. Let's focus more on numeric targets." Clearly, they don't do it right away because there's both the labor participation rate and the unemployment rate. You have to think about why the Fed is motivated to do that to understand why we are going to have inflation. [Fed chairman Ben] Bernanke thinks that tightening monetary policy in a great-depression-type of environment is one of the worst things you can do. The problem is that the market can do the tightening for you because as we saw in the spring time, we have a couple of good economic data points coming out and the bond market is selling off. The way you would try to prevent the bond market from selling off is by promising to keep interest rates low by engaging Operation Twist, by having an open-end purchase program so that market can't price it in right away, or by shifting away entirely--that's the next phase which we are in right now--by saying, "Listen guys, we are focusing on the employment rate, which means we want inflation." The reason we want inflation in Bernanke's view is that we want home prices to go up to bail out millions of homeowners that are underwater because downsizing isn't politically popular because there isn't enough real wage growth to pay off the debt. So we might as well push up the price level.

At the same time, of course, no policymaker at any central bank will ever tell you they want inflation. But you are in a boiling-frog type of environment, where the stuff you buy from Wal-Mart hasn't gone up in price, but at the same time the cost of health care and all kinds of other things have gone up. And so one day you will wake up and say, "Oh my God, why do I pay now $50 for parking here in a hotel rather than $20 or $10?"

Benz: So, Chris your portfolio, the ETF Multi-Asset Portfolio, gives you a lot of latitude to invest in different inflation-protection instruments. Let's talk about what you think belongs in that toolkit for people attempting to build kind of a bulwark against inflation in their portfolios?

Goolgasian: Sure. So, there are a lot of weapons in the real-asset toolkit for all of you guys. Obviously, there are things like inflation-protected bonds, there are things like real estate, there are things like commodities, and there are things like equities that are related to commodity production. And so what we've done institutionally for a long time is blend those four asset classes in different weightings to provide to endowments and defined-benefit plans inflation protection.

So, the goal is to beat CPI by a certain measure, and generally that is a measure that's greater than what a TIPS bond would provide you. So, what we've done with this ETF, which RLY is the ticker, we've blended those same four asset classes--commodities, equities related to commodities, real estate, and inflation bonds--and we hold those asset classes in a slightly different mix, but we also tactically maneuver between them.

This tactical asset allocation is a form of active management in which we are trying to over and underweight commodities versus equities or TIPS versus real estate to try and add extra value.

I think the important note here is that in an environment where all returns are compressed as they are, as you guys know, in the bond market, and also in the equity market. If you can have 1% or 2% of alpha in a real asset portfolio, that can be sizeable given the absolute level of returns. So, you're trying to beat inflation, and you are hoping these asset classes can do that for you. But on top of that active management could also help you do it.

Benz: Now, I'd like to talk about each asset class on kind of a one-by-one basis, and I'd like to start with TIPS, Mark, which is an asset class that you focus on in a couple of your products. TIPS are usually considered sort of the cleanest hedge against inflation, or the most direct hedge. Let's talk about what you think is the attractiveness of that asset class over the near term and over the long term?

Carlson: On TIPS with the inflation component that is baked into the security, they are a very good inflation hedge for near-term inflation. They respond very quickly. Within the TIPS market, I'm basically talking about the shorter-duration TIPS, as well, because if you look at some of the correlations, you can look at very short TIPS in their correlation like with the price of oil. Very short TIPS break even with the price of oil. They track very closely to each other; they're very sensitive to each other. So, short TIPS have always been a poor man's way to hedge against oil prices.

We introduced the strategy because believe it or not, it's difficult to transact in TIPS securities, individually. You wouldn't think that because with Treasury securities, they should be liquid, they should be easy to transact, and unless you are transacting in size, you really don't get good execution in TIP securities. So most people, most advisors go into a product. What most of the existing products do is they give you a market-weighted of either the entire spectrum of TIP securities or some slice of the maturity curve.

Well, what we've found is that one of the inherent problems with TIPS is that they suffer from duration drift because they are inherently fixed-income securities. So one of things is you use TIP securities as an inflation hedge. It's just like in medical practice when you're treating a problem with a patient and here's a problem in your portfolio being the impact of inflation. The first rule of thumb for a physician, for a portfolio manager, for an advisor would be, first, do no harm, and by investing in TIPS, you are introducing interest-rate risk into a portfolio when you're trying to effectively hedge inflation. The problem with broad-based TIPS products is that they suffer from duration drift because the durations of TIP securities drift over time because of changing inflation expectations. They also change in broad products because of the issuance of the U.S. government changing patterns, whether they're issuing five-year, 10-year, 20-year, or 30-year bonds.

So we came up with a strategy based on portfolios that we were running for endowments and foundations where we were targeting duration. So we went through a process where we were identifying the nominal modified adjusted duration of the TIPS portfolios, and we would target a duration in there so that we knew we could provide exactly for our clients an exact measure of the interest-rate risk that they were adding to their portfolio. And in the process, too, we found the ability to outperform market-weighted benchmarks at the same time, mainly because in the TIPS curve, both tails of the TIPS market suffer from market anomalies. I mentioned the impact on very short TIPS from the impact of oil prices. On the long end, there is really no natural buyers of it, and a lot of that market tends to get stripped, so the TIPS securities are broken apart. And in order to put those back together in the secondary market, it gets very expensive so they become very near and dear. So, what we found is we were able to produce better risk-adjusted returns in the belly of the curve, in the immediate part of the curve. So, we took that active strategy. We worked with our partners at Markit to build iBoxx indexes where we targeted three and five-year nominal modified adjusted duration so that we can provide our clients with inflation hedging. It's the same inflation hedging you get from any TIPS security but with a targeted duration of either three years or five years so you knew exactly how much interest-rate risk you are adding to your portfolio.

Benz: Chris, now TIPS are in your toolkit, and you are tactical, so I'd like to hear how you have made adjustments over the past year or so in terms of your TIPS allocation?

Goolgasian: We've been generally underweight TIPS, and there's nothing wrong with TIPS on the surface. But the attractiveness of equities and real estate, in particular, has been much greater in our valuation component than TIPS have been. So, we have been pretty risk-on this year in the portfolio, pretty bullish, pretty aggressive. And so in a mix in which TIPS are basically your only fixed-income allocation, when you are aggressive you will tend to be underweight TIPS and overweight the equity, overweight the real estate, overweight the commodities. So, we've been underweight TIPS by about 700 basis points to 800 basis points for most of the year.

Merk: If I can just toe in to be devil's advocate, some food for thought for TIPS, and one of them is clearly while you get enough bang for the buck with TIPS, if you are an investor moving toward retirement, your consumption basket is going to be different than the CPI basket and so forth. But there are two things I want you to think of, specifically when the Federal Reserve engages in quantitative easing, not when they buy mortgage-backed securities, but when they buy Treasury securities, a portion of that is also to buy TIPS. So the Federal Reserve makes these securities to be intentionally overpriced, just like government bonds are intentionally overpriced by intervening in those markets, and so through that alone you don't necessarily get all the inflation compensation.

And the other implication that goes much broader beyond TIPS is that historically the Federal Reserve sets interest policy based on feedback it gets from the yield curve. By looking at gauges of the economy throughout the yield spectrum, it sets monetary policy. It doesn't just look at historic unemployment numbers and inflation numbers, but looks at forward inflation numbers and the like.

Well, the Federal Reserve is flying blind these days. The Federal Reserve has no idea what the market thinks about future inflation. Bernanke brags about how great the policies are because the market is well-behaved. Well, the reason the market is well-behaved is because the economy doesn't go anywhere. Let's see how the market is going to behave if indeed we do have a pickup, and so with anything in the bond market and TIPS included, you may want to take with a grain of salt what the market is telling you. And if you want to beat inflation, well Bernanke has his toolbox and by all means investors may want to have their toolbox. And each one of these assets has its advantages and disadvantages. Just something to think about with TIPS.

Benz: Mark, before we leave TIPS, I'd like to talk about how you handled the inflation adjustment with your products? You have sort of a different way of doing it than other TIPS ETFs do?

Carlson: Well, that's the targeted duration around what we do with our products, so controlling the interest-rate risk. So, our products are designed to retain the benefit of the TIP security, the inflation component flow-through. But what we do is manage the interest-rate duration, so that interest-rate risk can be managed by the advisor or the client.

Benz: Let's talk about gold as the next asset class. I think one thing that has always bothered me about gold as an inflation hedge is that it's an extraordinarily volatile asset, and inflation normally has sort of this slow, steady drip-drop effect that takes a bite out of your portfolio. Axel, I know that you like gold quite a bit, but you also acknowledge that this volatility is a problem.

Merk: By all means. I mean, gold by many ways--people call it a barbarous relic because you don't use it much for anything. Well that's the beauty of it. Because it has fewer industrial dynamics, it's the purest indicator of the monetary madness that's out there. There have been some charts floating around the Internet of late. If you add up all the quantitative easing that's been happening around the world, the growth of the balance sheets correlates almost perfectly with the rise of gold. So, yes, it's been volatile, but we've been taken on a volatile ride by central banks.

If down the road, if you think that we have too much debt in the developed world and inflation is going to be part of how we're going to address that, gold by all means should be doing very well. But we fully agree that gold is quite volatile, and so depending on people's risk assessments, they want to gauge how much they want to have in it. It's one of the reasons why we advocate currencies because you can get a lot of what you get in gold, just with a much lower risk profile. Indeed, for the folks that hate the euro out there, for the longest period the euro has had the highest correlation to the price of gold. Tell any gold buck to substitute their gold holdings with the euro holding and they will probably, well if they're friend they'll laugh at you. But gold clearly, if we are in an inflation environment, is something that people want to consider. Now, there are many things that gold does and many things that gold doesn't do for some people. People get very emotional about it. But in the long run, one of the views we have is that policymakers only act and engage in reform when the bond market forces them to do that. In the U.S., we have patched up all of our problems. The bond market is well-behaved. That means inflation is a path of least resistance, and the price of gold is very clearly reflecting that.

Benz: Chris, how about you?

Goolgasian: So we have been very bullish on gold for quite a long time in our tactical portfolios. I think to narrow everything down to the current environment, there is no simultaneous hedge available for inflation other than as was mentioned, you could buy shorter TIPS. So the problem you are raising is gold has a lot of volatility, and yet you want to hedge shorter-term inflation. That problem exists for every asset class. Real estate is the same, and commodities are the same. It's very hard to find simultaneous hedges for inflation, so we just have to accept that.

The question is over the longer term, not in simultaneous months, is gold going to protect your purchasing power from the debasement that is going on worldwide? And we believe that it is. And gold, as you all know, cannot be conjured up and created, and in fact, very importantly, in the last 10 years the production of gold on the chart looks like this. Production in the last 10 years of gold is flat. The supply has not increased out of the earth. Consider that when you think about the price of gold. When the price of commodities goes up, the commodity producers get to work because they want to sell at those higher prices. And with the price of gold going up as it has, they still have not been able to produce more gold. That tells you that the supply is constrained.

The supply of money is not constrained as evidenced by how much more is printed every day, and so the connection between gold and paper is definitely psychic. It's something that has had all of our psyches for millions of years; gold is that device. It has attractiveness to us. In this day and age of money printing, that attractiveness is probably going to be realized in a lot more discussions about gold coming back to back currencies, and ultimately it doesn't have to actually happen, but the thought and the movement that that could happen is what will help drive gold up further.

Merk: If I can just disagree with that last point. People talk about, "We like gold. We think ultimately gold will prevail." But unlike what many gold bucks think, we have been moving further and further away from the gold standard over the last 100 years. And so what we tell investors is throw out that risk-free component out of your portfolio and don't trust the government to reintroduce a gold standard. If you like the gold standard, create your personal gold standard. And so the Chinese central bank is diversifying to gold and a basket of currencies. Well, you can do that in your own portfolio and your clients' portfolio, as well. But don't rely on the government of reintroducing the gold standard. They love to print money. And if you try to fix your problems, well you see what happens in Europe; it's not that easy. And so you may think that if you change the political party, be that in the U.S. or somewhere else, your problems are going to go away, but it's always [politicians saying], "The other guy is spending badly, and we are going to spend it on the better projects." Ultimately, we will continue spending money. We are not going to have the majority in Congress fix our issues, and so the path of least resistance is going to be inflation.

Goolgasian: If I could take 5 more seconds from Jim Lehrer on this one. I agree we move further and further toward money printing and further and further away from a gold standard. The answer to that should be, "And look where it's gotten us?" At some point there will be massive regime change where the Keynesians are out and the right-minded people are in. That may take a very long time, but there is a chance that that transition will happen, and we have to consider that. That's very bullish for metals.

Merk: I don't disagree. Just keep in mind, the difference between that regime change happening in the U.S. versus Europe. In Europe the current account is imbalanced. In the U.S. we have a current account deficit. If our bond market tells us to get our act together, the implications for the U.S. dollar are far greater, at least we believe so, than the implications have been for the euro because the euro is actually surprisingly strong to many, not to talk about the euro followers, but that's one of the key differences. The euro is less vulnerable because they actually don't need that money from abroad to keep the currency stable, whereas we do need these inflows. So, if suddenly our bond market acts up, the risks to our U.S. dollar with that inflation induced by a weakening dollar, I believe, are far greater.

Benz: Axel, one of your theses behind your currency-focused products is that a basket of foreign currencies, a well-chosen basket of foreign currencies, can actually provide a hedge against inflation. Let's talk about, how that works and walk people through that thesis.

Merk: A couple of things, and this raises a couple of issues. We talked about commodities, TIPS, and the volatility of gold. The nice thing, first of all, about the currency market is the volatility is far lower than in many other asset classes. TIPS maybe can compete with that. But when the euro moves a full cent on a percentage basis, that is very little. Nobody talks about when your stock moves from 1.28 to 1.29, but when the euro moves from 1.28 to 1.29 or today to 1.30, it's a big deal because it moves major economies. And not only is the volatility lower, it is far more consistent. If you want to have a predictability of a risk in your client portfolios, look at the currency markets. In 2008, the annual standard deviation of the dollar index moved from about 10% to 13%. Well, in the equity markets, it moved from 25% to the 40s. And so that's the first thing; you want to make sure that your risk profile is contained.

Second of all, that's pretty clear. A basket of currencies is less volatile than a single currency is, just as like a single-equity security is less volatile than basket is. Third, I mentioned the active management portion, in the current environment--and we've had it in recent years and we foresee it in the coming years--we've had this very active engagement of policymakers. Investors are no longer investing based on fundamentals, they are chasing the next possible intervention. Our view is why do you buy something like Cisco if the only reason you are buying it is because of QE3, when you can express that in the currency markets without the noise of the equity market at far less volatility. If there is one good thing to be said about all policymakers, be it Obama, be it Merkel, be it the Greek prime minister, is that they are quite predictable. You kind of know what they are up to. You know what Bernanke is up to. And so we think actually currencies are far easier to understand--worry about 10 major currencies a couple of other ones versus thousands of stocks.

If you look at the balance sheets of central banks, that's already proved proxy about which currency might outperform the other one. Obviously, it's a little bit more than that. But people always think currencies are so very complicated. No, they are not. You need to have your framework of analysis just like with anything else, and by all means, no we don't think that the carry trade is necessarily going to make you wealthy, especially when policymakers change the rules along the way. But you can make a macro analysis and add value with active management in the currency markets because these markets are far less efficient than many of the other markets around.

Benz: So, when you survey the foreign currency landscape today, which foreign currencies do you feel most comfortable aligning yourself with?

Merk: Well, again there is no perfect alternative. I'd like to remind people, last summer we got a lot of pressure from our investors saying why don't you buy the Swiss franc? And so, well, see what happened, [the Swiss government] intervened. Or look at Australia; everything is going well in Australia. Well, no, some things are not so great there, but that means that currency is very pricey. Look up north, everything is better in Canada. Well, yeah well but the Bank of Canada just does something to tweak and the loonie gets a little bit weaker. Or look at the eurozone. Everybody hates the euro, and then suddenly [European Central Bank presided Mario] Draghi comes out and makes the euro less risky than it was before. That doesn't mean that euro is safe suddenly, but when central banks have printed all this money and it flows to the second-tier currencies and there has been a flight to quality in the U.S., well, suddenly there is a shift toward the euro because it's less risky than it was before.

So, there is no single answer. It's one of the reasons why we allocate baskets and a managed basket of currencies because if it was so easy that you just put all your money into gold or into the euro or the Canadian dollar, we wouldn't be sitting here. I mean, investments is about having the maximum pane to try to find out where you want to put your eggs.

Benz: So, let's go ahead and take some questions from the audience members. There are microphones in the middle of the room, and if you have a question just feel free to step-up and go ahead and ask it.

Unidentified Speaker: Can you address gold versus a basket of commodities?

Benz: Chris, you want to take that one; gold versus a basket of commodities?

Goolgasian: Sure. So, I'm going to give you a short list here. I gave lot of talks about real assets and [people ask], "What are the reasons to own these things?" I'd say, global incompetence, global growth, global warming, and to hedge my wife's spending at Target. Global incompetence we've already covered, I'll skip that one.

Global growth. We have forgotten what it's like to grow, and I would say that growth is the outlier that no one is pricing in right now. But if we grow again, recall in the early 2000s and the mid-2000s, the booming emerging markets are the most bullish thing that can happen for broad-based commodities. You know a lot of data, but I'll just give you one point. China accounts for 50% of the world's cement usage. These are astounding days we live in in terms of potential growth. So, broad-based commodities that go into the economy--not so much gold--will benefit from global growth.

Global warming. Whether you believe it or not the fact is that global warming is very good for commodities. It's very bad for us as humans, but tsunamis, [Hurricane] Katrina, and drought--all of these types of things. Commodities have positive exposure to event risk. There's almost no other asset class that has that.

To hedge my wife's spending at Target. It sounds like a joke, but it's true. We are all in the financial-services industry, which we have seen shrink. We've seen comp be tough to come by, it's tough to grow your top line. It's also tough to cut your expenses, very tough in my house. And so if I can't cut the expenses, the best I can try and do is hedge some of them, and commodities can help you hedge some of your costs. Again, they are not perfect simultaneous hedges, but over long term they can hedge some of your actual spending.

Now to specifically your question about gold versus a broad-based group of commodities, the commodities that are used in economic utility in building and construction and transportation and everything else, they need global growth. They can benefit from QEs because the dollar weakens and the commodity prices go up. But that tends to be shorter and more transient.

Gold should be viewed as the play on the debasement of the currencies. It should be viewed as the physical item that could possibly replace currencies or substitute down the road and not be viewed as an item that helps out or benefits from growth of the economies as much as oil or natural gas or copper, et cetera, would.

Merk: Maybe if I can just throw-in the other side of that gold versus currencies. We in our currencies strategy use gold, but we don't use any other commodities; not even silver. It comes down to the fact that gold is just a lot easier to understand; the dynamics get more complex. I fully agree there is plenty of money to be made in commodities and by all means consider commodities, but depending on the risk profile you are looking for, currencies, gold, commodities have a different place in somebody's portfolio.

Goolgasian: And I would just add, in terms of analogies, we don't own silver, and we get asked quite a bit about that. And I say, "Gold is the house to silver's condo." And so in real estate markets when real estate markets boom, condos have more beta than houses, right. Condos go up more than houses in up markets and condos go down more than houses in down markets, and silver has that same profile. And that's OK. If you are bullish on gold, you'd probably be more bullish on silver. But the fact is when you have an investment process and a rationale for why you own gold, it is specifically around debasement and around potential replacement currency; silver does not fill that role.

Carlson: At Northern, we use gold as an alternative currency. We don't even use it in our inflation-hedging bucket. We've been overweight gold for several years right now, but we look toward TIPS and the natural-resources equities and commodities for the inflation hedge, but we don't look to gold. That's more in Axel's world as in a currency basket.

Benz: Let's talk about why you would use natural-resources equities as well as commodities because it seems when commodities hit the scene everyone was quite excited about them as perhaps the substitute for natural-resources Equities?

Carlson: Because the correlation is moving closer and closer. Commodities still retain probably the leadership and depending on what cycle you are talking about or which one in terms of correlation to inflation. But natural-resources equities, especially if you can isolate the ones that have the majority of their business concentration at the development in the production, ownership of the assets have been gaining in terms of correlation. One of the other benefits that plays into the currency play as well is that it's very easy to invest in a natural-resources company in ex-U.S. so you get the currency hedge against the U.S debasement, as well. So, that market has moved closer and closer to being a more effective inflation hedge than it was say 10 or 15 years ago.

The other thing is that we are a little bit concerned about what might go on in terms of the regulatory front. You think about it, here we are four years after Lehman Brother's collapse, and the regulators, even though Dodd-Frank has been passed, there are still hundreds of rules still to be written. They haven't even gotten to the futures market yet. Whether or not they are going to attempt to handcuff the retail investor into the futures market is unknown. It's probably not going to be a major restriction, but there are still some regulatory unknowns going forward. So that's something that you have to be concerned about. But what we believe is you use natural-resources equities as a strategic allocation for commodities, and then you use commodities as tactical.

Benz: Mark, would you also put real estate in that inflation bucket?

Carlson: The way we approach inflation hedging, we chop it up into three terms. So for the very short term, one to five years, we recommend TIPS in that environment. And then in the intermediate term, five to 20 years, we recommend natural-resources equities and commodities. And then, longer term, we are looking at real estate and infrastructure and then the private ownership of natural resources, where you can put stuff in an illiquid basket like going out in private ownership of timberland or farmland and sea-mineral rights.

Benz: Let's tackle another audience question, if you could step up to the microphone please.

Unidentified Speaker: My question is, I can understand the rationale of using gold, for example, as a longer-term strategic inflation hedge, and this question is really open to all three of you. But during times of stress and market turmoil, which could conceivably in the future be inflation-driven or inflation-scare-driven, you typically see, because of the positioning, liquidation across all of these types of risk assets, gold included. So it's conceivable that you'd have an inflation scare and your models are thrown askew, because gold has actually short-term gone down. And I think TIPS, too, are prone to distress due to positioning or liquidations of positions. How do you square that? How do you ensure you maintain your proxy hedge and yet live through the volatility? I mean, clearly, you have clients and clients don't like volatility, regardless of the long-term view you have. So, you have the longer-term view, but you need to manage the shorter-term portfolio volatility. How do you do that? Do you look to buy out-of-the-money options? What do you do, or do you just live through it?

Merk: If I can maybe start on this one. First of all, in 2008 gold did very well compared with many other alternatives, but clearly, especially in the last two years, gold has very highly been correlated with riskier assets. The most important measure that I use when I talk to a retail person is you've got to be able to sleep with the exposure you have, and you've got to show the investor this is how volatile gold can be during the most volatile periods. And by the way silver is far more volatile. Silver can move 10% in an hour. Gold moves a lot, not quite that much.

Then beyond that, of course, it's about diversification. It is one of the reasons why we advocate currencies so much because the risk profile is just so much more contained. And if you look at other alternatives, REITs in particular, well REITs might be a great inflation that's in the long term, but the correlation to the S&P 500 is enormous. So, there if you have an investor that wants to have gold, well they usually like the upside but they don't like the downside risk. And so if you have too much of it, they want to sell out. Another thing by the way, what we have seen when you have an investor that has a managed product--it doesn't matter whether it's currencies or something else--they tend to stick with it for the longer term. Whereas if you have an investor specifically buy an asset, say the Australian dollar or say gold, then the moment it turns down, well investors panic. Whereas if they give it to a professional to manage, they tend to hold it a little longer, of course, until they lose the trust in the manager and then they take it all out. But still by sometimes have a structured product or an ETF that's a basket of things, it sometimes encourages investors to be longer-term-oriented just like when you buy the timberland, you're less likely to trade it than when you can sell something with the push of a button. But then we go into investor psychology and much more than we can cover here.

Goolgasian: It's a very good question, and I think the answer is that it depends on the nature of the scare, as you put it. So what you have seen and are referring to is, when there is a scare about liquidity, and people are afraid that they can't get their money out of the banks, which has happened in Europe a number of times last couple of years, you get this run, because people actually these paper dollars, granted they are depreciating, but they want them.

And you actually see a bunch of other assets being sold, and gold gets lumped into that list. So that causes some volatility in the short term, but you have to step back and say ultimately, "Is that bullish or bearish for gold?" It is very bullish when people are afraid of their currency and afraid that they can't get it out of the banks. So, you have to separate forced selling in the short term for liquidity purposes versus the big picture of, "Are these actions likely to be more beneficial or detrimental toward people's attitudes to physical currency instead of paper currency?" And the answer is, given enough time they are very bullish.

Unidentified Speaker: The main focus is that you've got to experience that short-term volatility. You go into that strategy knowing that this will tend to plateau.

Carlson: Yes.

Merk: I think one of the challenges and one of the reasons this issue comes up is, Warren Buffett I think has said you should like an asset more when it's on sale, whereas nature is, of course, you want to sell it when it goes down. And part of the challenge in today's environment is we just don't know what's going to happen. We don't know, and we think people get scared because every pundit says something else. So I think the most important thing is that you have a vision of the world, and we try to have a very clear framework. We update it; we don't try to be dogmatic. But as long as policies happen along that vision, then your investment strategy is possibly right. And then you update it, of course, as new information comes available. But just because this week the glass is half full and tomorrow the glass is half empty, you don't sell out your portfolio. I mean that's one of the reasons you design a longer-term portfolio, but it's much more easily said than done. So that's why you want to make sure that whichever clients you have, that they agree to the vision that you lay out, and then it's much easier to go through the short-term volatility that you're faced with just about any investment.

Benz: I have a question for the panelists. Assuming I have carved out a portion of my portfolio that I am going to dedicate for inflation-fighting investments, how do I decide how large that should be?

Carlson: Current allocations within Northern's master asset allocation is relatively small. Strategically, we're only at 2% allocation to TIPS, 2% to commodities, and 6% to gold?

Benz: So does that depend on the investor, though? Does life stage figure in there at all?

Carlson: It does. It's life stage and then the risk profile. This would be indicative of what you would call a normal client, say someone in the middle age, and a moderate risk taker. Obviously, if you have a more conservative client, you would be less in terms of commodities and gold, higher in terms of TIPS, and the other way of the spectrum if you had a maximum aggressive client risk profile.

Benz: Axel or Chris, any take on that question?

Goolgasian: I'll give you two quick frameworks to think about. One would be to invert your confidence level in the policymakers' ability to exit this. So if you are 90% confident that they can exit this correctly, then just have 10% in real return-type asset classes. If you're only 60% confident that they can exit this correctly, then you should have a lot more, maybe 40%. I would say you need enough to move the needle. There's a lot of window dressing in our industry. You hold this and you hold this, but it doesn't matter. I think generally you need to have something like 15% to 20% to move the needle on a portfolio. So those are kind of rules of thumb that I have in my head.

The second way to think about is in terms of what institutional money does; defined-benefit plans, endowment plans, sovereign wealth, foundations. And you will find that generally commodities are 4% to 5%, real estate is 4% to 5%, and TIPS varies depending on what their goals are. But if you add all of that up, you will generally see something in the 15% to 20% range, as well, which kind of gets you toward the same number.

Merk: I think that's an excellent answer. I'd just like to add some food for thought on top of that. If you think about the election, the most important thing about this election is going to be who is going to be the new Fed president, who is going to be elected in early 2014. If we get an Obama administration, maybe Bernanke wants to continue, maybe we get Janet Yellen who is now, vice chair formerly [the president of the Federal Reserve Bank of San Francisco]. We get Christina Romer who is at [the University of California at Berkeley]. Each one of those three favors an unemployment target and to varying degrees, and so it's further cutting the link between inflation and monetary policy.

Now if we get a Republican administration, odds are we get somebody like [Columbia University professor] Glenn Hubbard who says well we've printed too much money, let's mop it up. Now let's think about it. What happens if we go down that road? It's different from the early 1980s where we could zoom up interest rates. We just can't do that. We can't do if Bernanke said we'd raise rates in 15 minutes because we have so much leverage in the economy. So, if the attitude of a Glenn Hubbard is, well, let's reduce the balance sheet of the Fed, let's take the pain now, let's have it early in the administration, so we can then go back to a more sound monetary policy, well, you might be up for a rude awakening because as soon as you raise interest rates a little bit, the economy might just fall apart because we are not yet out of the woods, so to speak.

So what you can expect then is a very volatile Fed policy that they'll try to do the right thing. Policymakers that we speak to, both active and passive, are convinced they can fine-tune that. Our view is nothing has worked the way that policymakers have [intended]. And so with that, my personal assessment is that, well, all of investing is about beating inflation in some ways, protecting purchasing power, and so that's why you use stocks and commodities and currencies and whatnot.

At the same time, as I indicated before, why do you take on the equity risk when the only reason you make investments in equities is because of the monetary easing that's happening, when you can do it in a more targeted fashion in commodities, in currencies with alternatives? And so in my personal portfolio, it's greatly overvalued, those sort of issues, but clearly, you have some fiduciary guidelines and so you can't necessarily have that flexibility. But I just want to keep your thinking that, think out-of-the-box, and this inverse relationship I think is a very good way to look at it.

Goolgasian: If I can just add one idea if you guys have some spare time and don't get bored easily, read something called the Woodford Paper which is on the Federal Reserve website. It came out around the time of the Jackson Hole Economic Summit. And to what Axel was talking about, it specifically suggests that a 7% unemployment rate could be a target, and the sentence is, "and 3% inflation." There's a conjunction in there--"and." Those are very, very aggressive targets from where we are.

Now, last week or two weeks ago when Bernanke announced infinite quantitative easing, that Q&A is also available. So to Axel's point that these guys are predictable, one of the best things about observing monetary policy is there is a long record and history that you can look at to understand their behavior.

So, go back two weeks and you can find the 25-page Q&A after the announcement that Bernanke had with the press, and in that Q&A he talked about the Woodford Paper and he also said, my colleague and friend Woodford. Now, Bernanke uses his words very carefully. So he is telling you he is putting a lot of credence in this paper, and this paper is very aggressive about monetary policy.

Merk: By the way, Bernanke you may like him or not, he is predictable. Everybody should read his Helicopter Ben speech 10 years ago. You can Google "helicopter Ben speech," and Google will send you to the Federal Reserve page, not to some arcane website. Bernanke does what he says. He has a framework of thinking. Read what he says in Jackson Hole. In the springtime at a press conference, he said let's be humble. What he meant with that is, let's not mop up liquidity too early because we don't know whether we're out of the woods yet. It's a little different interpretation of the word humble that I was taught when I learned English. The policymakers are predictable and with that, well, take their advice at your own peril. That in just concluding from that gold should be doing well.

Benz: Well, I think we are going to have that be the last word. I want to thank my three panelists Axel Merk from Merk Investments, Chris Goolgasian [from State Street], and Mark Carlson from Northern Trust. Thank you. Thanks for being here.