Morningstar Investor users sign in here.

Video

How you can hedge your portfolio against inflation

Morningstar FundInvestor editor Russ Kinnel describes some direct and indirect hedges for inflation protection.


Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Inflation is making a comeback this year, in the new issue of Morningstar FundInvestor, editor Russ Kinnel unpacks a variety of direct and indirect hedges for inflation protection and whether they're worth owning. He's here today to share his take.

Thanks for being here, Russ.

Russ Kinnel: Glad to be here.

Dziubinski: Let's start by first taking a step back and talk a little bit about what's going on with inflation today, and how big a risk it really is to certain types of investors.

Kinnel: The latest reported inflation has definitely ticked up. It's up about 5% year-on-year, though of course a year ago, as you recall, the economy was hitting the brakes. So it's not a perfect number, but inflation is definitely picking up. I think, though, it's probably not necessarily expected to continue rising. I think it's a bit of a threat, but it's not a big threat, because some of this is just the economy ramping back up, hitting some bottlenecks. So most economists expect things to settle down. Of course, if you're watching the bond market, the bond market is acting like there's no inflation. So the bond market signals that the consensus is inflation is not out of hand.

Dziubinski: And you point out in your article that bond-heavy portfolios are in fact, a little more at risk when it comes to inflation. What types of bonds and bond funds in particular face the greatest inflation risk?

Kinnel: Really, it's the higher-quality ones, where a lot of your value is coming down the road when you get the payment at the end. And so that tends to be longer-term bond funds, higher-quality bond funds, they're more susceptible to rising inflation.

Dziubinski: You talk in your article about two different types of funds that are considered to be more direct inflation hedges, the first being funds that invest in Treasury Inflation-Protected Securities. Let's talk a little bit about how these funds work, how well they really do guard against inflation, and what the caveats are.

Kinnel: This is obviously a pretty direct hedge because the Treasury issues inflation-protected securities, in which the principal is adjusted up and down based on the CPI. So essentially, you're pretty much protected that you will get that interest rate, and then it will adjust for inflation. And so there are funds that own these TIPS, either on a short-term or long-term maturity. These are pretty direct hedges that you can really depend on--you're not going to get big yields, but at least you've got some protection there.

Dziubinski: And then a second direct inflation hedge that you talk about in your article are commodities funds. Let's talk a little bit about what the different types of commodities funds are, what they're investing in, and again how good of a job have they actually done protecting against inflation.

Kinnel: That's right. Commodities, you're getting sort of the other angle, and this is, you're essentially investing more or less directly in commodities. So typically, a commodities fund will have a lot of energy exposure, some agricultural exposure, and some precious metals exposure. Those are all obviously components of inflation and tend to surge when inflation is on the rise. Now, of course, commodities are far more vulnerable than TIPS. So if you own a TIPS fund, year-on-year you might have some ups and downs, but it's pretty mild-mannered. Commodities funds are very much boom or bust. Next year, you might make 50%, you might lose 50%. So it's a very volatile hedge, you have to be pretty careful in using it because it really is one of the most volatile mutual fund types out there. So you definitely have to be careful, I think the best way to handle that is, if you're going to invest there, keep it at 5% or below of your portfolio, because you just don't want it dominating your portfolio. It's just really volatile. And the long-term returns lately have not been very good. Obviously, that can change, but you definitely have to be careful there.

Dziubinski: And then you talk about a couple of more indirect inflation hedges in your article one being bank-loan funds, let's talk a little bit about those, and under what environments bank-loan funds would do pretty well against inflation.

Kinnel: Bank loans adjust for changes in interest rates. So these are loans to corporations, almost all of them are below-investment-grade. And they adjust as interest rates change. Interest rates and inflation tend to go in the same direction, but it's not a perfect hedge. So it tends to be close, but particularly in a short run, they don't have to move in sync.

Dziubinski: And then lastly, there are gold funds. Let's talk a little bit about those. How good of a job they do against inflation; they seem to be another one of those boom-or-bust types of funds as you referred to earlier, right?

Kinnel: Exactly. It's very extreme performance. They tend to do well when inflation rises, they tend to do well when the economy has a problem, there's some world crisis. But they don't always do that. Sometimes they sell off sharply. So, it's fairly random. And of course, if commodities funds include gold as one component, having just gold is less great, I think as a hedge because it's only one component. Of course, for most of us gold is not a big input in our actual purchases, day to day. So it's a useful hedge, but again a limited one.

Dziubinski: Well, Russ, thank you so much for your perspective on these inflation hedges and not-quite hedges today. We appreciate it.

Kinnel: You're welcome.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

 



© 2023 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This report has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or New Zealand wholesale clients of Morningstar Research Ltd, subsidiaries of Morningstar, Inc. Any general advice has been provided without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782.

More from Morningstar

Bank results: the winners and losers
Video

Bank results: the winners and losers

Morningstar analyst Nathan Zaia explains how the banks did and what the future holds.
How to deal with financial stress
Video

How to deal with financial stress

More high-income earners are now also experiencing financial stress. We go through practical ways to reduce it
UniSuper CIO John Pearce on why the 60/40 portfolio is far from dead
Video

UniSuper CIO John Pearce on why the 60/40 portfolio is far from dead

The $130 Billion SuperFund Manager also talks about how he sees risk, his recent investments, and why history isn’t a good guide to the future.
Incitec Pivot: explosive upside ahead?
Video

Incitec Pivot: explosive upside ahead?

Morningstar analyst Mark Taylor believes imminent growth in explosives earnings could lift sentiment.
Why Morningstar see opportunities in coal stocks
Video

Why Morningstar see opportunities in coal stocks

Analyst Jon Mills explains why he’s recently increased fair value estimates for Australian coal companies.
Is the sharp fall in ResMed's share price justified?
Video

Is the sharp fall in ResMed's share price justified?

The potential for weight loss drugs to impact the sleep apnea giant has weighed on the share price, though Morningstar analyst Shane Ponraj thinks...