Inflation Hedge

Art by Karlotta Freier

Annual inflation grew to 7% this past December, a pace not seen since June 1982, according to the Department of Labor. With that rapid escalation, advisers’ clients may be seeking to add inflation-hedging components to their portfolios. And advisers have several appropriate options, 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 it within fixed-income assets, preferring to preserve more of their risk asset budget, they might be limited to using only Treasury inflation-protected securities.

For investors with more flexibility, however, there might be better options. 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 up the value of the underlying bond when inflation rises and adjusting the value down when inflation declines, says Russel Kinnel, director of manager research for Morningstar. TIPS’ yields are typically 2% or less, and, due to those low yields, the vehicles 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, though inflation and interest rates often go in the same direction, this is not always the case; TIPS funds can lose value because interest rates rose but inflation expectations did not.

A five-year TIPS investment has returned about 5%, while natural resources have gone up about 19%, real estate about 18%, and infrastructure about 9%, McDonald says. These will provide good inflation protection and a better return opportunity than will TIPS. Still, investing in those assets vs. TIPS does come with extra risk, he says. 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 channel 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, this can be partially mitigated by taking a diversified approach when picking stocks, McDonald says. This can mean diversifying geographically—using a global approach—and by industry, to limit overall exposure to any one group.

Bobby Blue, a senior analyst with Morningstar’s manager research team, says, when choosing different securities, investors should rely on good, bottom-up research as they make their selections.

“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 says. “You want [the manager] to be thoughtful about the way it picks these assets, the way it combines them, the way it’s allocating among the different assets. And you want a thoughtful risk-and-return profile with those underlying assets.”