Morningstar's Top Picks for Inflation Protection

Over the past decade, many investors have learned some hard lessons about attempting to predict the direction of inflation. In the wake of the financial crisis, many pundits believed that the Federal Reserve's accommodative interest-rate policy would lead to runaway inflation. But sluggish global growth was an even more powerful force, and the U.S inflation rate has languished: The most recent reading, through October 2016, was just 1.6%. That was higher than previous readings, but well below historical norms and the Federal Reserve's target of 2%.

Yet financial markets are sending signals that inflation could be more of a concern in the future than it has been in the recent past. President-elect Trump’s stated preferences for tax cuts, looser regulations, and infrastructure spending have prompted a rally in stock prices, but bonds have sunk on concerns that those policies could lead inflation, as well as interest rates, to soar.

To illustrate investors' heightened concern for inflation, the differential between the yield on a nominal (i.e., one that's not inflation-adjusted) 10-year Treasury bond and the yield on a 10-year Treasury Inflation-Protected Security has jumped since Trump's election. That differential, often referred to as the break-even rate because it means that inflation would have to advance by at least that much for the TIPS investor to be better off than the buyer of non-inflation-protected bonds, jumped from 1.71 on Nov. 7 to 1.97% just three weeks later.

That demonstrates that the market prices in inflation expectations on an ongoing basis, so investors looking at inflation-protective investments for a near-term payoff may well be disappointed; inflation worries are already getting priced in, to TIPS' prices, at least. Moreover, it's possible that still-anemic global growth could continue to put the brakes on inflation.

Yet even if inflation doesn't prove to be a near-term risk, it's still valuable to think through your long-term strategy for preserving the purchasing power of the assets in your portfolio. Holding an ample dose of stocks is a sensible starting point for investors at all life stages: While stocks aren't a direct hedge against inflation, the asset class gives them the best shot at out-earning inflation over time. Retirees ought to be even more concerned than accumulators about building a direct bulwark against inflation, especially if they have substantial shares of their portfolios in fixed-rate investments whose income streams get eaten away by rising prices. This article takes a closer look at rightsizing your portfolio's allocations to inflation-hedging investments.

Here's a closer look at some of the key inflation-protective investment categories, along with Morningstar analysts' top picks within each.

Direct Hedges: TIPS and I Bonds The thesis: Both Treasury Inflation-Protected Securities and I Bonds are considered direct inflation hedges because they compensate investors for increases in inflation over their holding periods. With TIPS, investors receive an adjustment to principal to reflect inflation; the bump-up in yield is indirect, because as principal increases, so does the yield that the TIPS holder earns. With I Bonds, the yield is adjusted to reflect CPI.

Morningstar's top picks: Investors can buy I Bonds directly from TreasuryDirect.gov, and that's arguably the simplest and most straightforward way to obtain exposure to inflation-protected bonds. However, new purchases are subject to annual limits of $10,000 for electronic versions and $5,000 for paper bonds, and the latter can only be purchased through tax refunds. That means that, in practical terms, large buyers will have a difficult time amassing a meaningful stake in I Bonds.

For Treasury Inflation-Protected Securities, Morningstar analysts have generally recommended that individual investors consider mutual funds rather than buying individual TIPS due to trading complexities in the latter. Among Morningstar's favorite funds are

. Indeed, a host of low-cost inflation-protected ETFs have come to market in recent years. Schwab US TIPS ETF SCHP is the cheapest of these, with an expense ratio of just 0.07%. iShares 0-5 Year TIPS Bond STIP has the longest track record of any of the short-term TIPS products and charges 0.10% per annum.

Know before you go: Before buying a TIPS fund, investigate its duration, a measure of interest-rate sensitivity. As discussed in this article, many core TIPS funds feature a fair amount of rate-related volatility and are, therefore, most appropriate for investors with holding periods of at least five years. Also, note that some intermediate-term bond funds have been buying TIPS of late; Morningstar's portfolio breakdowns for bond funds gives you a sense of whether you already own TIPS via your general bond fund. (The Barclays U.S. Aggregate Bond Index doesn't include TIPS; so if your core bond exposure is an index fund, you can safely add to TIPS without duplicating your efforts.) Like all taxable-bond types, TIPS funds are best housed in a tax-sheltered account like an IRA, because yields, and the inflation adjustments on them, are taxed as ordinary income.

Direct Hedges: Multiasset Inflation-Protection Funds The thesis: Such funds, discussed in depth here, bundle together a variety of investments, usually Treasury Inflation-Protected Securities, commodities, real estate, and other asset classes, with an eye toward out-earning inflation over time. The goal is to provide a one-stop, diversified portfolio bulwark against inflation, so that the investor doesn't have to assemble a lot of smaller positions.

Morningstar’s top picks:

The Gold-rated

Bronze-rated

Know before you go: Morningstar doesn't have a dedicated multiasset inflation-protection category; rather, most of these funds reside in the tactical asset allocation category or one of the static-allocation groups. And don't look for these funds to shine in a period in which inflation is underwhelming: Morningstar's research demonstrates that in the mild inflationary climate that has prevailed since most of these funds came to market in the wake of the financial crisis, returns have beaten inflation but lagged a plain-vanilla 40% equity/60% bond portfolio. Many such funds have been buffeted around by their commodities exposure, which has boosted their volatility and detracted from their returns. (See the commodities discussion below for a closer look at what has been going on in that category.) Finally, while these funds all vary in their complexions, most of their underlying holdings aren't tax-friendly.

Indirect Inflation Hedges: Bank Loans The thesis: Bank loans don't provide a direct hedge against inflation, but their returns have tended to be positively correlated with inflation. That's because the loans they invest in have interest rates that "float" along with the London Interbank Offered Rate (Libor); when Libor is trending up, inflation is often on the move, too.

Morningstar's top picks:

Four bank-loan funds currently receive Morningstar Analyst Ratings of Bronze, including

Know before you go: Bank loans tend to be lower quality and, as such, they usually behave in sympathy with the U.S. economy and the equity market. Thanks to terrible losses among the category's junkiest and least-liquid entrants, the average bank-loan fund lost a stunning 30% in 2008. Clearly, bank loans are no substitute for high-quality bond exposure and certainly aren't cash alternatives; they should be used in small doses within the context of a broadly diversified portfolio. And because their income payouts have the potential to be high, bank-loan funds are best housed in a tax-sheltered account like an IRA.

Indirect Inflation Hedges: Commodities-Tracking Investments The thesis: Commodities investments enable investors to participate in the price gains (and losses, recently) of commodities. When inflation is running high and eroding investors' purchasing power, a commodities investment can gain, helping to offset those price increases.

Morningstar's top picks:

Morningstar's top-rated commodities mutual funds are both from PIMCO:

, both rated Silver. The former, a category veteran, offers an inflation-protection two-fer: Management tracks a commodities index using derivatives that require just a small amount of collateral, then buys Treasury Inflation-Protected Securities with the remainder of assets. (Harbor Commodity Real Return HACMX

is a no-load near-clone.) PIMCO CommoditiesPlus Strategy also tracks a diversified commodities index, though its manager also takes long and short bets in an effort to outpace it; this fund, too, invests in a basket of bonds alongside its commodities-derivatives exposure.

Know before you go: Commodities are extremely volatile and the slide in energy and basic-materials prices globally has shown them at their worst. Moreover, a phenomenon called "negative roll yield," discussed in this video, has further weighed on the returns that investors in commodities futures funds have earned. Though returns have perked up recently, the typical commodities fund has lost 10% on an annualized basis during the past five years. Commodities-futures funds are best held in tax-sheltered accounts, as gains are treated as 60% long term and 40% short term (taxed at your ordinary income tax rate).

Indirect Inflation Hedges: Real Estate The thesis: Whether you own it directly or indirectly, real estate is generally considered an inflation hedge because real estate prices often move in sync with the general inflation rate. Moreover, owners of rental properties, like the office buildings and shopping malls that populate REITs, can charge higher rents in inflationary environments.

Morningstar's top picks:

Morningstar has two Gold-rated REIT funds:

Know before you go:

If you own a total market index fund or a good value fund, chances are you already have some real estate exposure.