Looking to Add to Your Inflation-Fighting Repertoire?

The potential for a rising inflationary environment has been on investors' minds as the Fed and other central banks around the globe continue to enact monetary policy to spur growth and employment after 2008's downturn. Expansionary monetary policy has kept interest rates artificially low in an attempt to encourage investors to shift into riskier assets, but it's also increased the potential for higher long-term levels of inflation that could eat into investors' real (after inflation) returns or erode their assets' purchasing power. Predicting when higher levels of inflation might set in and to what magnitude is not a game that even the most skilled investors attempt to play, so considering how to protect investors' portfolios from inflation down the line might be worth exploring now.

Asset classes that have proven over time to have some correlation to inflation are often referred to as "real assets." Though that term can mean different things to different people, real assets tend to include inflation-linked bonds (Treasury Inflation-Protected Securities and their non-U.S. counterparts), commodities, real estate investment trusts, natural-resource stocks, and master limited partnerships. Morningstar does not have a separate category for funds dedicated to real assets, though they tend to fall mainly in the inflation-protected bond, commodities broad basket, and world-allocation categories. A basic search for funds with "real asset," "real return," or "inflation" in their names yields a starting point for identifying such funds.

The concept of investing in real assets is not new, but investors have tended to use single tools as their inflation fighter. One popular choice is carving out an allocation to TIPS, which have an explicit link to inflation. The value of TIPS is contractually linked to the Consumer Price Index, a widely followed measure of core inflation. TIPS bonds' face values are adjusted in line with the CPI, providing principal protection and increased interest payments over time in an inflationary environment. The largest fund in the category,  Vanguard Inflation-Protected Securities (VIPSX), has been around since 2000 and holds nearly $45 billion in assets.

However, with the fund paying a negative real yield of 1.0% as of Nov. 16, 2012, some investors may be wary of what negative real yields represent. Currently low real yields can raise the question as to whether investors' inflation expectations are overblown, and therefore whether investors are paying too much to own TIPS. In addition, rising interest rates not related to CPI can affect TIPS short-term prices. The main point is that TIPS can be a useful tool for hedging inflation, but are not necessarily a panacea for all inflationary pressures.

Commodity funds have also garnered a sizable following, especially over the past decade. Most of the funds in the commodities broad basket category track a diversified commodity index (such as the Dow Jones UBS Commodity Index or the S&P GSCI) using a basket of derivatives. The Dow Jones UBS Commodity Index is split almost evenly among the three main sectors: energy, agriculture, and metals. By contrast, the S&P GSCI is more energy-heavy with 68% exposure to energy, 22% to agriculture and livestock, and 10% to metals. Gaining exposure to the commodities market via derivatives requires only a small portion of a fund's assets, so most funds invest the remaining assets in short-term or cashlike securities. The largest fund in this category, $21 billion  PIMCO Commodity Real Return (PCRIX), takes a different approach. Lead manager Mihir Worah stashes the remaining assets in an actively managed portfolio of U.S. TIPS, non-U.S. inflation-linked bonds, and corporate debt. As such, this fund has benefited from the tailwind of a declining interest-rate environment since its 2002 inception, in addition to the strong bull market commodities have enjoyed over the past decade.

Commodity-focused funds are not without drawbacks. The commodities market has long been touted for its diversification benefits and low correlation with equities, but those assumptions have been challenged in recent years, including during 2008's downturn. They also generally come with a big dose of volatility. That volatility can be amplified in a rising interest-rate environment, which will likely challenge the fixed-income portions of these funds. What's more, non-inflation-related elements can affect commodity prices in the short term, such as severe weather events on the price of agricultural commodities and conflict in the Middle East on the price of energy-related commodities. Thus, a sole allocation to commodities is an imperfect inflation hedge as well.

Real estate investment trusts have also historically offered some protection against inflation due to the entity's ownership of real estate and their ability to increase rents to offset increasing prices from inflationary pressure. REIT open-end mutual funds have been around for more than 20 years, and the Morningstar real estate category has amassed nearly $70 billion in assets. One of the earlier entrants,  Cohen & Steers Realty Shares (CSRSX), is the largest actively managed offering in the category at $4.8 billion. While REITs exude some inflation-hedging attributes, REIT funds' returns can be highly correlated with equity markets and, as is the case with all equity securities, won't always be priced attractively. As investors flocked to income in the uncertain economic environment during the past couple of years, they drove up the price of many equity REITs for reasons that had very little to do with inflationary pressures. As Morningstar's Director of REIT research Philip Martin pointed out in an outlook for real estate stocks at the end of the 2012's third quarter, equity REIT shares were trading at an estimated 15% above fair value, compared to the average long-term historical premiums of 5%-10%.

Smart Minds Think Alike
Due to some of the potential drawbacks mentioned above, investors may be better served by gaining exposure to a variety of asset classes that respond to different inflation factors. A number of asset managers have come to a similar conclusion--since the beginning of 2010, fund companies have launched more than 20 funds that allocate between several real asset classes. Based on these funds' multi-asset class structure, they tend to land in the moderate-allocation, conservative-allocation, or world-allocation category. In general, these strategies tend to look quite different from the majority of funds in the category in which they reside, so their Morningstar rating and relative performance versus category peers may not always paint an accurate picture. For example,  Principal Diversified Real Asset (PDRDX) falls in the moderate-allocation category, but its seven-sleeved structure, which includes sizable allocations to commodities, REITs, and natural-resources stocks, will tend to perform much differently compared with its more-straightforward balanced-fund peers.

At this point in time, we have rated three funds that set out to generate a real return by allocating between several different real asset classes. Each fund takes a slightly different approach to achieve that goal, but each can be used as a one-stop-shop for inflation protection.

PIMCO Inflation-Response Multi-Asset (PIRMX)
Rating: Silver
Lead manager Mihir Worah and his team allocate among five inflation-related asset classes: U.S. Treasury Inflation-Protected Securities form the largest component, followed by commodities, emerging-markets currencies, REITs, and gold. While emerging-markets currencies are not necessarily considered a real asset, the currency exposure can help protect against a falling U.S. dollar. Worah will tactically adjust the fund's positioning based on PIMCO's macroeconomic outlook and real asset views and invest in out-of-index securities such as floating-rate notes and non-U.S. inflation-linked bonds.

The fund only recently celebrated its first birthday, but Worah's success on  PIMCO Real Return (PRRIX) and  PIMCO Commodity Real Return (PCRIX), core components here, allow for optimism despite a short track record. The team behind  PIMCO Emerging Markets Currency (PLMIX) has also impressed, and Worah makes use of that fund for the emerging-markets currency sleeve. Worah also allocates roughly 0.5% of assets per year to tail-risk hedges (mainly put options on stock markets) to shield the portfolio from losses greater than 15% in any single year. All told, the fund's unique design, flexible approach, and proven skills backing it make this fund worth a look.

 Fidelity Strategic Real Return (FSRRX)
Rating: Bronze
Lead manager Joanna Bewick and a team of sector specialists divide the fund's assets between TIPS, floating-rate bank loans, commodities, and REITs. Fidelity looked at markets back to 1973 to understand how they've behaved in a variety of inflationary environments to construct the fund's neutral asset mix: 30% inflation-related securities (primarily TIPS), 25% floating-rate bank loans, 25% commodities, and 20% REITs and other real estate investments. Bewick and comanager Ford O'Neil will make adjustments depending on relative valuations and their outlook on short- and long-term macroeconomic trends, though adjustments tend to be modest.

Each of the fund's asset-class sleeves is run by a separate manager; the team actively manages the portfolio's REIT and bank loan sleeves and aims to provide more indexlike exposure in the TIPS and commodities sleeves (the commodity-linked portfolio is managed against the Dow Jones AIG Commodity Index). As with the other funds in this group, it has yet to face its true test--a sustained period of inflation--but the fund's design makes sense and may appeal to investors seeking consistent exposure to these asset classes.

 Principal Diversified Real Asset (PRDAX)
Rating: Neutral
Principal hires primarily external subadvisors to manage the fund's seven-sleeved approach. Launched in mid-2010, the largest components are 30% in TIPS, managed by  BlackRock (BLK), and 20% in commodities, managed by  Credit Suisse . The other half of the portfolio is divided evenly among global real estate investment trusts (Principal Real Estate Investors), natural-resources stocks (Jennison), Master Limited Partnerships (Tortoise Capital Advisors), global infrastructure (Brookfield), and floating-rate debt (Symphony). For the most part, this is a solid batch of subadvisors with strong track records. The fund's strategic allocations to global infrastructure and MLPs set it apart from its other rated peers, but the managers here keep the allocations within 5 percentage points of target weights, so its lacks the wide flexibility for tactical allocation.

Given the relative youth of this group of funds, as well as a generally small asset base, most have yet to be rated by Morningstar's fund analysts. As we continue to add funds to our Morningstar Analyst Ratings for Funds list, many of these real return or real asset funds could become candidates for expanding coverage as investors continue to search for ways to protect their portfolios from future inflation.