Ways to protect your portfolio against inflation

Dollars & Sense

April 13, 2003|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

If you've been increasing your investment in bonds and money market funds during the bear market, you might want to sit back and assess how well your portfolio is protected against inflation. If your nest egg doesn't keep up with inflation, then it's really shrinking in value because it will buy less with each coming year.

The good news is the mutual fund world has created some offerings that can help insulate you from the sting of inflation. Before taking a look at them, however, here are some specifics about how inflation may affect your investments:

INFLATION AND BONDS: Inflation is a problem for most bonds because they pay a fixed rate of income. If a bond pays a 5 percent yield and inflation is 1 percent, you get a 4 percent return. If inflation kicks up to 6 percent, you get a negative 1 percent return in real terms. In addition, that bond loses value on the open market, so instead of getting par value, you might get only 83 cents on the dollar. (If you hold it to maturity, you'd still get par.) A bond fund updates its net asset value every day and will adjust it for any changes to the underlying price of its holdings. So, inflation hits you on two fronts.

For long-term investors, the pain is mitigated somewhat by the fact that you can reinvest your coupons in higher-yielding bonds, and over time that will make up for some of the losses. With interest rates near all-time lows, bond portfolios are particularly susceptible to rising inflation and the increase in interest rates that would be spurred by it.

If you own stocks or stock funds, you already have some inflation protection. Stock prices get marked up just like cans of tuna, gallons of gasoline and blue jeans in part because the companies you own sell these products. As long as companies can raise the prices of their products in step with inflation, shareholders have an inflation hedge. If you own your home, that's another form of inflation protection. Still, these are rather crude forms of insulation. You can't be sure that they will keep pace with inflation since prices of different goods go up at different rates.

There are two mutual fund alternatives that offer better inflation protections, however. One is rather plain-vanilla and can easily be incorporated into your bond portfolio, and the other is more of a Tabasco flavor that's best used sparingly.

TIPS FUNDS: The Treasury sells inflation-protected bonds whose par value is adjusted to rise and fall based on the Consumer Price Index. Thus, you could significantly reduce your inflation risk by shifting up to a quarter of your high-quality taxable-bond portfolio into TIPS funds.

The main caveat here is that the market for TIPS isn't fully mature yet, so pricing of the bonds has been a little unpredictable. Early on, TIPS appeared to be cheap as the market gave them the cold shoulder. Later, however, investors warmed up to them, and they rallied beyond the point suggested by fundamentals. On the whole, TIPS have been relatively volatile. If you're buying for more than a year or two, those issues shouldn't be too much of a problem as the market matures.

If you're in the market for a TIPS fund, start by looking at Vanguard Inflation-Protected Securities (VIPSX) and Fidelity Inflation-Protected Bond (FINPX). The Vanguard fund is cheaper with an expense ratio of just 0.21 percent compared with 0.50 percent for Fidelity. If you're a load-fund investor, you should consider PIMCO Real Return A (PRTNX), which focuses mostly on TIPS and charges 0.90 percent. All three have excellent managers who should do a fine job of seeing shareholders through to their goals.

COMMODITY-LINKED FUNDS: There are only two members of this club. Mutual funds aren't allowed to buy commodities directly, so commodity-linked funds buy derivatives that track commodity prices. The end result is quite similar to a direct investment in commodities. The strategy throws off a lot of income, though, so these are best left in tax-sheltered accounts such as IRAs and 401(k)s.

Commodity prices change rapidly, so these funds will definitely act like Tabasco in your portfolio.

Oppenheimer Real Asset A (QRAAX) tracks the Goldman Sachs Commodity Index, which is dominated by energy prices. PIMCO Commodity Real Return Strategy (PCRIX) is a new entrant that tracks the Dow Jones-AIG Commodity Index, which is more evenly spread among different commodities and therefore may produce a somewhat smoother ride.

We don't have much of a record for the PIMCO fund, but these offerings are clearly volatile. This year, Oppenheimer Real Asset has been on a wild ride. It gained 9 percent in January and 12 percent in February, only to lose 14 percent in March.

By contrast, Vanguard Inflation-Protected Securities' worst monthly loss was a little under 3 percent, and its biggest monthly gain was 8 percent. That's pretty volatile for a bond fund, but, as I said, the market may settle down in the coming years. Not so with the commodity funds. A little can go a long way in taming inflation risk, and they'll always be bouncing up and down, so I wouldn't go over a 5% portfolio weighting with these offerings.

Both the Oppenheimer and PIMCO funds are primarily load funds, but no-load investors can get into PIMCO Commodity Real Return Strategy D (PCRDX) through Schwab's NTF program.

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