How you can hedge your portfolio against inflation

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.