Investment Tip of the Month


Morningstar Investment Research Center’s Picks for Inflation Protection

by Christine Benz, Director of Personal Finance

If there’s a small silver lining amid the current economic malaise, it’s that inflation has been pretty muted.

But investors ignore inflation at their own peril. Even if massive amounts of government stimulus don’t prompt inflation, there’s the possibility of price spikes here in the United States as a result of still-red-hot economic growth in emerging markets. Widespread rising prices, in turn, could amount to erosion in the purchasing power of any assets you’ve managed to save or invest. By the time you start tapping your portfolio to meet your income needs, those dollars could be worth a lot more than they are right now.

That’s why it’s so important to ensure that your portfolio is adequately protected against inflation. Some inflation-fighting vehicles have explicit protection against rising prices, such as Treasury Inflation-Protected Securities. Others, such as stocks, protect against inflation indirectly.

Here’s an overview of the key vehicles with inflation-fighting attributes, as well as some of Morningstar’s top picks in those groups.

Inflation-Protected Bonds
The Thesis
For holders of nominal (that is, not inflation-protected) bonds, inflation is a natural enemy, right up there with rising interest rates. If an investment is delivering a fixed payout, inflation will reduce the value of that payout accordingly. That’s where inflation-protected bonds come into play. There are two main varieties: I-Bonds and inflation-protected bonds. The former are bonds for individual investors issued by the Treasury Department; their yields adjust upward to reflect changes in the Consumer Price Index. Inflation-protected bonds, such as TIPS, are similar, but the inflation adjustment comes at the principal level, not in the bond’s yield.

Best Bets
There are no funds composed of I-Bonds, but there are a number of offerings that focus on inflation-protected bonds. For plain-vanilla TIPS exposure, it’s tough to beat the low-cost Vanguard Inflation-Protected Securities VIPSX; for ETF enthusiasts, iShares Barclays TIPS Bond TIP is another low-cost, no-nonsense choice. The PIMCO-managed Harbor Real Return HARRX, meanwhile, has successfully employed a broader toolkit that encompasses non-U.S. inflation-protected bonds and the use of forward contracts to obtain TIPS exposure. While SPDR DB International Government Inflation-Protected Bond WIP isn’t an official ETF Analyst Pick, it provides both inflation protection and diversification away from the U.S. dollar.

Bank Loans
The Thesis
Unlike inflation-protected bonds, bank loans don’t include an explicit mechanism to ward against inflation. But they stand to be fairly hardy when inflation is on the move. That’s because bank-loan payouts fluctuate in line with the London Interbank Offered Rate–the rate that banks charge one another to borrow money. When the LIBOR heads up, which is often the case during inflationary environments, so do bank-loan coupon payments.

Best Bets
Bank-loan funds might seem to have it all: imperviousness to rising interest rates plus some inflation-fighting characteristics. But investors should tread with caution in this varied category. As a result of credit sensitivity and forced bank-loan selling from institutional investors, the average bank-loan fund lost 29% in 2008. Morningstar’s favorite fund here is one of the group’s slow and steady options, Fidelity Floating Rate High Income FFRHX, where manager Christine McConnell assiduously avoids the market’s riskiest loans.

Commodities/Metals Funds
The Thesis
The premise behind owning commodities investments for inflation protection is straightforward: If the prices of goods are going up, an investment that captures price changes in food, energy, and basic-materials costs will thrive at the same time.

Best Bets
Although the case for commodities for inflation protection is straightforward, the implementation isn’t. Owning the stocks of commodities companies, as with an offering like T. Rowe Price New Era PRNEX, provides indirect exposure to the prices of stuff. And while commodities futures-based funds aim to provide broad and direct exposure to the prices of goods, in practice they haven’t been perfect trackers of commodity prices as a result of a situation called contango. Morningstar’s open-end fund team doesn’t currently include any commodities offerings among its Analyst Picks. Our exchange-traded fund team, meanwhile, has a few commodities picks, including iPath DJ-UBS Commodity Index DJP.

Stocks
The Thesis
Stocks are another indirect way to gird your portfolio against the threat of inflation. Their returns are variable, in contrast with fixed-rate investments, giving them the potential for higher returns than bonds. That means that inflation could take a smaller bite, in percentage terms, out of your future purchasing power.

Best Bets
Not all stocks will thrive in an inflationary environment, and some companies may even see their profitability flag. To help identify companies with a strong history of profitability through a variety of economic environments, screening for firms with high returns on equity is a good starting point. Morningstar Investment Research Center’s preset Wealth Creators screen can help you identify such firms, and layering on an additional screen for wide moats will further winnow down the universe to companies with long-term competitive advantages. Fund investors have a few top options, including Vanguard Dividend Growth VDIGX and T. Rowe Price Dividend Growth PRDGX (traditional actively managed funds) and the index fund Vanguard Dividend Appreciation (available as a conventional mutual fund VDAIX and exchange-traded fund VIG).

A version of this article appeared on Morningstar.com on Dec. 9, 2010.

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