October 19, 2012 / 4:16 PM / in 5 years

COLUMN-Four ways to squeeze inflation risk from your portfolio

6 Min Read

By John Wasik

CHICAGO, Oct 19 (Reuters) - While inflation has been tame in recent years, there are few forecasters who believe it will remain so in the future.

But when inflation bites again is a moot question. Predictions of its imminent return have been wrong for years. The key is having portfolio protection in place now so that it won't devastate your fixed-income holdings and reduce your future quality of life.

Because even having been forewarned, it's not so easy to protect your portfolio against inflation, which will erode your purchasing power over time. The difficulty is that there's no perfect hedge against it. Treasury Inflation-Protected Securities (TIPS), are the natural choice, but they are linked to the flawed Consumer Price Index (CPI).

Commodity funds and gold are worthy considerations, although they have their shortcomings as well. Keep in mind that commodities and gold have their own cycles based on supply, demand and other factors, so past returns may not be reliable indicators of what the future holds. There's a reason why commodities are so volatile.

A blended portfolio that employs a number of inflation beaters is the best approach. Just be careful to balance it according to the amount of risk you can stomach.

TIPS gain in value when inflation is rising, but are an imperfect gauge of prices. In a disclaimer published with every CPI report, the government states "the CPI is a statistical estimate that is subject to sampling error because it is based upon a sample of retail prices and not the complete universe of all prices."

The CPI comes up short, for example, in tracking housing prices, which are partially measured through "owner-equivalent rents." And it's not a complete measure of the broad spectrum of commodity prices, which can be better tracked -- although imperfectly -- through commodity funds.

No matter how you measure inflation, it's clear that it can impair your purchasing power and depress bond prices. What's more important is whether you are able to keep up with the rise in the cost of living.

The latest CPI report from the U.S. Bureau of Labor Statistics showed a 2 percent annual increase in September. While that number was mostly driven by higher energy prices (gasoline, fuel oil), it was rising at the fastest pace since April. The more telling figure is inflation-adjusted hourly earnings, which fell 0.3 percent from August to September. Wages aren't keeping up with inflation and this has been a problem for years. Fortunately, there's something you can do to bolster your portfolio.

In deciding upon an inflation hedge for your portfolio, you have to weigh the risk-return trade-off. I asked Prof. Craig Israelsen, a finance professor at Brigham Young University, to generate four different portfolio allocations that illustrate the risk-return scenario:

1. Replacing bonds with TIPS - Let's say you are concerned that inflation is coming back and also astutely concerned that your bonds will lose value. You want to keep it simple, so you have a 60 percent stocks, 40 percent TIPS allocation. Your 3-year annualized return through Sept. 30 would be about 12 percent and nearly 8 percent over a decade. That's about two percentage points better than a standard 60-40 mix of stocks and bonds. The volatility, as measured by three-year standard deviation, would be a relatively low 9 percent.

2. Replacing bonds with metals - With the same stock percentage, you invest 40 percent in a precious metals fund instead of bonds. Your 10-year return rises to 11.4 percent while your three-year performance drops to nearly 10 percent. Volatility, however, more than doubles to about 20 percent.

3. Reduce stocks to 50 percent - Keep bonds at 30 percent with 20 percent in precious metals. Your three-year volatility drops to just under 13 percent with three- and five-year returns just under 10 percent.

4. Half stocks, 30 percent bonds, 20 percent commodities - Your three-year return rises to just over 10 percent, while over the decade you gain 8.5 percent. Volatility, though, drops about two percentage points over the previous portfolio.

As you can see, it is easy to capitalize on the "anxiety premium" that metals pay and capture some of the global demand that commodities funds track. But these strategies come at a price in terms of higher volatility and higher fund expenses. How do you construct these portfolios? The simplest way is through low-cost mutual and exchange-traded funds.

The iShares Barclays TIPS Bond ETF tracks an index of U.S. inflation-adjusted bonds. Stocks can be represented by the SPDR S&P 500 ETF. A worthy bond ETF is the SPDR Barclays Capital Aggregate Bond fund. Metals are tracked by the Vanguard Precious Metals and Mining Fund ; commodities by the PowerShares DB Commodity Index Tracking fund .

While TIPS are an imprecise, though less-volatile, tracker of the cost of living, they move in the opposite direction of stocks. If you lean towards conservative investing, TIPS may be a better fit than metals or commodities, although it's not a bad idea to incorporate some metals and commodities to cover a broader range of inflation threats.

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