Inflation Protection Ideas

There is no shortage of opinion in either direction about inflation. But really the only thing most folks probably care about is how higher prices for everyday items like gas, food and healthcare and how lower prices for their homes affect them. It stands to reason that people would each view this differently.

I don't think people should be so fixated on the current value of their homes, but they are. My own take is that a lot of people would be more concerned about what was a $400,000 house a year ago now being $360,000 than about gas being $10 more per tank or spending $12 more at WalMart every week. However, I would not argue with anyone saying the $10 and $12 are more important.

Regardless of what you think about inflation rates, we have had relatively low inflation over the last decade or so, and having it be a little higher for a while seems reasonable. It therefore makes sense to build some inflation protection into a diversified portfolio. That might mean TIPS to some folks or gold to others. Equities can help offset inflation over the long term; or maybe REITs are the answer.

This brings us to a related comment left by long-time reader OG. He said he is not sure what the optimal mix of gold and TIPS would be.

The chart below (click to enlarge)comparing StreetTracks Gold Shares (GLD) and TIP (both of which are client holdings) probably makes it clear as mud what the mix should be.

I don't see any sort of correlation, but I do believe that both of them serve important inflation-related purposes. However, they will deliver different effects to a diversified portfolio. Since 1971, gold has had huge moves up, a huge move down and periods of seemingly not doing much. You obviously expect much less action, as shown in the chart, from TIP.

If you believe in both, and I do, but are not a fan of volatility, then perhaps an equal mix of the two could help with managing the volatility. For what it's worth I tilt a little heavier to TIP versus GLD, but I have some mining stock exposure which has done well. I think of it as more of a regular equity holding than a pure inflation hedge.

A close to even split may not seem too interesting, but the most important thing is having any exposure at all. At different times, obviously different mixes would be the best. When GLD was going up to $100 you should have had more GLD. When GLD was headed down to $84 you should have had more TIP. If you are not likely to win between the two, then it is better to just focus on whether owning the asset class is appropriate for you.

OG then followed up with an idea for an exchange-traded product tied to "real" CPI that he would only trust Barry to devise. Barry would be a good choice. I touched on this before too. I think the idea of indexing CPI rates from different countries, regions or other logical baskets of countries into an exchange traded product and perhaps leveraging them 1.5 to 1 would make for a very compelling security. A CPI basket of the GCC countries looks pretty good to me right now as long as those countries continue to peg to the greenback.

David Swensen and others have talked about inflation protection as being an asset class. This makes intuitive sense after all these years of somewhat low inflation. There have been a few other TIP products that have come along since TIP (maybe some of the OEFs are older than TIP). More importantly, this seems like a space that is destined to evolve into more innovative choices like the SPDR International Inflation Fund (WIP), which I own for some clients.

Obviously I think the CPI fund idea is interesting, but there must be others being studied in various labs throughout the industry. Picking up a few hundred basis points from increases in CPI plus a little interest seems like a good way to invest in what is happening on the ground in a region without taking stock market risk. It could offer a new type of emerging market exposure for folks not too comfortable with iShares Emerging Market (EEM) or other broad EM funds.

One last point about inflation protection as an asset class: You don't want it to be the best performing thing you own. Ideally stocks would be going up and inflation would be tame. Is there anyone who does not want that? Stocks always going up with tame inflation may not be real world, but I think that is what people would prefer--not that their hedges are doing great.

Comments

[J. Fredrickson:]

The problem with TIPS is the government provided inflation data has been manipulated to the point where it will always underestimate true inflation. So, if true inflation is at 8% and the government says it is at 3%, the TIPS really don't provide protection from the real inflation, the government doesn't have to pay out as much because of the bias number and the general public believes that inflation is tame while seeing their earnings taxed a second time. I am cautious of TIPS for this reason.

2008 May 20 02:50 PM

[David Lentz:]

The Powershares downside dollar ETF (UDN) looks a lot better than either TIP or WIP when I throw them up in comparison to GLD.

It is designed to replicate the performance of being short the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc.

That would seem to be a good way to avoid the effects of government fiddling with the CPI.

2008 May 20 06:07 PM

[David Lentz:]

Roger, I think you should have put that last paragraph in all-caps.

People often get so caught up in hedging, or positioning to take advantage of a recession or downturn (a difficult thing to do), that they forget that the goal in managing an investment portfolio is not merely to avoid shrinking it (although that is VERY important), but to grow it over time.

Choosing the risks to take and positioning a portfolio for a brighter future has got to be the goal, and downside protection merely a strategy to avoid the avoidable losses. Downside protection never grew a portfolio to the sky.

2008 May 20 06:14 PM

[notsosmart:]

as long as the govt. or anyone else with an agenda is in the numbers game there is very little you can do.fredrickson is so right. to the best of your ability you have to rely on yourself.the average u.s. citizen did not cause the '29 crash. the average hardworking employee @ enron,bear stern,etc did not cause the collapse.sadly,this will be the case more & more.

2008 May 21 09:15 AM

[Jimbo:]

I have a great deal of respect for Mr. Nusbaum and his astute judgments. However, I support the observation of Mr. Fredrickson(noted above) regarding the wisdom of investing in TIPS. My wife and I put a significant amount of our savings in Vanguard TIPS a few years ago. We have begun exiting our position because I believe the government is not keeping honest books on inflation. Our currency is being flown into the ground to bail out big money center banks who conducted themselves unethically and foolishly. Thus, the game is rigged against the little guy.

2008 May 21 01:03 PM