Investing for Higher Inflation

With the Federal Reserve Bank pouring some $600 billion of liquidity into the economy with QE2, after a decade of easy money, it seems a foregone conclusion that we can expect a bout of increased inflation, and sooner rather than later.  What can an investor do to protect his purchasing power?  Gold and silver have been the traditional answers, but these metals have their drawbacks, not least of which has been a meteoric rise over the past three years.  A more generalized commodities exposure is intellectually attractive, but vehicles for gaining that exposure are expensive and have structural problems.

Smart Money mentions three mutual fund categories that tout their inflation hedging properties.  Real return funds have proliferated recently.  Smart Money recommends avoiding funds heavily weighted in TIPS as the yields on these  bonds have been bid down to next to nothing.  I concur.

The second option is global bond funds.  The argument is that foreign countries, especially ones that export natural resources, are going to be somewhat sheltered from the effects of inflation, if not actually benefit from it.  As the commodity exporting countries tend to be emerging markets, and thus pay a premium yield, this can be true.  However, these are fixed income investments, and so values will decline as interest rates rise, as they will if inflation ticks up.  Also, emerging market economies tend to peg their currencies to the dollar, either formally or informally.  This peg could undermine the hedging benefit of foreign bonds.

The final suggestion is bank loan funds.  I have commented on these funds here.  Suffice it to say that, though these funds are being touted for their inflation hedging properties, there is a high probability that investors will be disappointed.

I heard a presentation on a unit investment trust (UIT) structured to be interest rate hedge.  The portfolio is constructed with a 20% weight in each of dividend paying stocks, closed end funds investing in convertible securities, closed-end funds investing in TIPS, closed-end funds investing in master limited partnerships, and closed-end funds investing in limited duration bonds.  This sounds to me like a more rigorous inflation hedge portfolio.  The dividend paying stocks and convertible securities reflect the research done at the end of the 70s and into the 80s showing common stocks to be highly effective inflation hedges, though I would probably leave them in the equity portion of the client's portfolio.  The TIPS are a natural portfolio inclusion and the MLPs are income producing hard assets  with a revenue stream tied somewhat to commodity prices.  I would probably forgo the short bonds, as they should already be represented in the traditional portfolio, and add some income producing real estate in the form of some REITs or a REIT fund.

There you have it.  An inflation hedge portfolio consisting of TIPS, real estate and MLPs.  There are low cost mutual funds and ETFs that will give you simple exposure very inexpensively.  Worth considering.