How to Protect Against Inflation

Annual inflation grew to 6.8% in November, a pace not seen since June 1982, according to the Department of Labor (DOL). With the rapid escalation in inflation, clients may be seeking to add inflation-hedging components to their portfolios. And advisers have several options that are appropriate, experts say.

According to Jim McDonald, Northern Trust executive vice president and chief investment strategist, investors will have to decide where they want their inflation protection. For plans that want inflation protection within fixed-income assets, not wanting to use part of their risk asset budget, they might be limited to only using Treasury inflation-protected securities (TIPS).

However, for those that have more flexibility, TIPS might not be the best option. Instead, real assets such as natural resources, real estate and infrastructure all present better return opportunities, McDonald says. The advantage of using real assets instead of TIPS is obvious if you compare them year-to-date, he notes.

TIPS are designed to protect against inflation by adjusting the value of the underlying bond up when inflation rises and down when inflation declines, says Russel Kinnel, director of manager research for Morningstar. TIPS yields are typically 2% or less and, because of those low yields, they are more interest-rate-sensitive than bonds of a similar maturity—either five, 10 or 30 years. Purchasing longer-term TIPS funds increases interest-rate risk, and, although inflation and interest rates often go in the same direction, that is not always the case, which can cause TIPS funds to lose money because interest rates rose but inflation expectations did not.

A five-year TIPS investment has returned about 5%, while natural resources are up about 19%, real estate is up about 18% and infrastructure is up about 9%, McDonald says. These are higher-risk assets that will provide good inflation protection and a better return opportunity; however, investing in those assets versus TIPS does come with extra risk, he adds. A key decision people must make is how much risk they are willing to take.

McDonald explains that investing in real asset companies can be beneficial during times of inflation because the companies can easily pass through price increases to their consumers. For example, landlords can raise rents if their costs are going up, and utilities usually have automatic pass-throughs to pass cost increases to the end customers. This gives many of these companies protection against inflation because it protects their profitability and, in some cases, can even lead to growth.

Although investing in real assets does increase overall risk, one way to mitigate that is by taking a diversified approach when picking stocks, McDonald says. A diversified approach can mean diversifying geographically, by using a global approach, and diversifying by industry, to reduce the risk of overall exposure to any one group.

During an interview, Bobby Blue, a senior analyst with Morningstar’s manager research team, noted that when choosing different securities, investors should rely on good, bottom-up research as they make their choices.

“What you want to avoid is a manager throwing all of these assets into a portfolio and saying, ‘Here’s my diversified real asset strategy,’” Blue said. “You want someone to be thoughtful about the way they pick these assets, the way they combine them, the way they’re allocating amongst the different assets, and you want a thoughtful risk-and-return profile with those underlying assets.”