Though U.S. inflation likely won’t be a problem until 2014 and beyond, it’s not too early for investors to start implementing long-term inflation hedges. But with so many possible inflation fighting investments out there, I continue to get lots of questions from clients and readers alike about the various protection strategies.
In the sixth of my ongoing series of posts dedicated to questions I receive, I’ve compiled some of these queries, along with my answers. If you have an investing-related question you’d like me to answer, please post it in the comments section below. Also, you can check out earlier installments here.
Q: Is gold no longer an inflation hedge?
A: Gold certainly can be an inflation hedge, and it has worked in the past. Obviously, one of the reasons gold has been weak of late is that people are becoming less concerned about inflation. Now, I don’t think you want to have a huge allocation to gold unless you’re really, really concerned about inflation, and I’m not. But gold also does two other things, which make it worth having in the portfolio in small amounts:
- It’s diversifying as it behaves differently than paper assets.
- Exposure to gold is also a useful strategy to take advantage of the negative real-rate environment. Typically, gold is a beneficiary when real interest rates become negative as this lowers the opportunity cost of holding the metal.
Q: What’s your assessment of Treasury Inflation Protection Securities (OTC:TIPS)?
A: I’m not that enthusiastic about this asset class because TIPS are currently not cheap. In fact, in this environment the real return on a TIP, i.e. how much money an investor gets back after inflation – is actually negative. In other words, investors in TIPS are basically paying the government to give them back an inflation-linked principal amount at a certain date.
Q: What asset classes might investors consider if they’re worried about inflation?
A: Having inflation protection in a portfolio is incredibly important and there are cheaper ways to get that protection than TIPS. While there’s not one substitute for TIPS, there are other asset classes that do a good job of hedging against inflation that investors may want to consider. Within fixed income, floating-rate notes and bank loans that will reset as interest rates go higher are options. On the equity side, some of the natural resource companies, and particularly energy companies accessible through the iShares S&P Global Energy Sector Fund (IXC), can do a very good job of hedging against inflation. And right now, those companies offer a fairly generous yield1. Finally, though I advocate it be a small part of a portfolio, gold can be an effective inflation hedge over the long term.
Disclosure: The author is long IXC
1. IXC Average Annual Total Returns as of 3/31/2013
Disclaimer: The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.
Shares of iShares Funds are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns.
In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Technology companies may be subject to severe competition and product obsolescence. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters. Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Diversification may not protect against market risk or loss of principal.