Should You Buy an Inflation Hedge?

Pick up the newspaper or turn on the TV and you're likely to be bombarded with stories about how surging inflation could stunt economic growth and throw investors for a loss. All this, of course, has been good news for fund companies hawking offerings billed as inflation hedges--think TIPS funds or commodity funds such as  PIMCO Real Return (PRTNX), which has swelled to approximately $14 billion in assets. (It had less than $1 billion in assets at the end of 2000.)

But is the case for these funds overstated? And more importantly, are they going to work as most people expect? The answer, unfortunately, is that it depends.

Let's start with why I think these funds don't make sense for a large percentage of the investors who have been piling in recently. To put it bluntly, these investors are not hedging against rising prices--they’re chasing performance. That's understandable given the strong recent showing of inflation-blunting offerings like  Vanguard Inflation-Protected Securities (VIPSX), which has gained 9.88% annually over the past three years, and  PIMCO Commodity Real Return (PCRAX), which gained 29% and 16% in 2003 and 2004, respectively, and is already up 10% this year. But that doesn’t make it wise, particularly in view of investors’ tendency to flock to hot areas just as they’re about to cool down.

Which brings me to my next point: Given that investors have been making a beeline to inflation- and commodity-linked offerings, it’s unlikely that the underlying securities are trading on inflation fears alone. To put it differently, when demand far outstrips supply, prices rise. In other words, it’s entirely possible that TIPs and commodity prices are, excuse the term, inflated.

That’s not just the contrarian in me talking. Many notable investors have turned cautious on these securities, believing that they are now overvalued. For instance, it's been more than a year since  Dodge & Cox Income (DODIX) had any TIPS exposure. Meanwhile, oil prices--the key driver of returns at most commodity funds--have reached levels that may prove to be unsustainable. And then there are some firms, such as Legg Mason, that continue to build their portfolios with low inflation assumptions, making clear that the support for higher inflation isn't as clear-cut as one might think.

The upshot? Even if we do get runaway inflation, investors who have flocked to these offerings may not get the returns they are expecting because the recent run in the prices of their underlying securities may already reflect some future inflation expectations. Just as the recent upswing in the prices of these securities has exceeded most expectations, the downside could surprise many investors in its intensity. A sudden spike in interest rates, for instance, could harpoon TIPS. Meanwhile, some of the commodity-linked funds could do even worse if the prices of their underlying securities or assets fall.

So, when should you buy these funds? Only when you're truly committed to employing them as part of a diversified long-term portfolio. In that case, you're likely to get the inflation protection you desire over a complete market cycle because the short-term (three, if not five, years) swings are less likely to influence your decision making. The key, of course, is that you need to be willing to stick with these funds through the ups and downs because there will be periods when they will be influenced by factors other than just inflation. As such, my advice to those in need of a portfolio reallocation, during a time when inflation-linked tools might be pricey, is to consider a dollar-cost averaging strategy, which should blunt the short-term price risk.

Don't get me wrong: I do think these are valuable diversification tools if used in a long-term planning context. However, my concern is that too many investors are buying these funds for the wrong reasons. These folks are likely in for a rude surprise sooner or later.