Inflation Hedging: How to Protect Your Portfolio

Includes: GLD, TIP, VDE
by: David Fessler

Right now, the markets are caring about one thing: inflation. And they’re starting to get a little edgy. They need inflation hedging…

Why? The U.S. Treasury is printing money and dumping it into the financial system at historically unprecedented rates, in an effort to stimulate the economy.

Chances are good that the Fed won’t know when to stop the printing presses. Continuing to print money only exacerbates the inflation problem and deepens the hole.

And it’s quite a hole.

Jessica Hoversen, Fixed Income Analyst at MF Global, had this to say Thursday on CNBC: “The ratio of U.S. budget deficit to [gross domestic product] GDP is at the highest level since World War II.”

The government thought process goes something like, “If some stimulation is good, more will be even better.” And most politicians, who are always looking ahead to the next election, won’t want to risk their futures by cutting off ANY economic aid prematurely.

It goes on and on…

The real problem though, is that all of this economic over-stimulation sets us up for inflation. It’s something every investor should guard against in his or her portfolio. And it’s why we’ve got the best four investments for you to hedge against inflation’s impact.

The Tried and True Inflation Hedge - Gold

These days, many think of gold as a great investment for its safety and growth. And solely based on the amount of direct-mail advertisements I get from gold bugs, you’d think it was the only investment worth keeping.

But in fact, it really is an effective inflation hedge against a declining U.S. Dollar and an inflationary economy. It’s why every investor should have some exposure to gold in his or her portfolio. As part of our Asset Allocation Model, we recommend 5%.

For all its benefits, there are currently two problems with the physical metal: It’s in great demand - and therefore hard to get - and purchasing it requires a stiff premium - in some cases, 10% or more - when and if you do find bullion or coins to invest in.

A much better way is to pick up a few shares of SPDR Gold Trust ETF (NYSE:GLD), which seeks to replicate the price performance of gold bullion. Shares of GLD trade at the ratio of 10 shares to one ounce of gold.

This investment trust holds the physical metal for investors in vaults: You can see what those gold vaults looks like.

HSBC Bank (HBC) serves as the custodian of the trust’s physical gold, and recently had to move it to a larger vault to accommodate growing investment.

A Stand-Alone Inflation Hedge - Inflation-Adjusted Treasuries

Our next inflation hedge is inflation-adjusted Treasuries (TIPS). These investment bonds stand alone in the investment world, as they’re the only investment guaranteed to beat inflation.

Essentially, they are Treasury bonds that hedge against inflation - the bondholder gets an interest payment twice a year, just like a standard Treasury note.

But the catch here - and it’s a good one - is that the bond principal increases each year by the amount of the consumer price index (CPI). And so does the amount paid in interest, which is exempt from state and local (but not federal) taxes.

While the bonds themselves can be purchased directly from the U.S. Government or any broker, the easiest way to participate in them is through the iShares Barclays TIPS Bond Fund (AMEX:TIP).

This fund seeks to duplicate the return of the Barclays Capital U.S. Treasury Inflation Protected (TIP) Securities Index.

And while regular Treasuries have lost 3.9% (including interest payments) this year, TIPS have returned 3.6%. That’s a full 7.6% better return than Treasuries with the same amount of safety.

Hedging Against Inflation With Energy Stocks

Our third hedge against inflation is energy stocks because energy figures into the cost of just about everything. And since oil and natural gas are priced in dollars, an inflationary cycle tends to raise the price of energy and energy-related stocks.

Of course, even without inflation, the long-term trend for energy prices is one way: up. Inflation will just add fuel to an already burning fire (pun intended).

Rather than looking at individual energy stocks, however, consider a shotgun approach in the form of an energy exchange traded fund or ETF.

One we like for its low fees and solid performance is the Vanguard Energy ETF (NYSE:VDE), which seeks to replicate the performance of the Morgan Stanley U.S. Investable Market Energy Index. It’s up over 29% since its March low.

Made up of a diverse group of large, medium and small cap companies in the energy sector it provides wide ranging coverage of the sector. In addition, it includes companies such as drillers, equipment providers, exploration, refining marketing and production and transport of oil and gas products.

As I find energy and infrastructure some of the most interesting opportunities in the markets today, investing in energy companies allows us to easily align our hottest investing ideas alongside inflation protection.

A Final Inflation-Protection Hedge - Commodities

Our final inflation-protection hedge is in commodities like wheat, cattle, fertilizer, and base metals - all usually rise during inflationary periods.

Until recently, profiting from commodities involved commodities futures trading, something that most people know little about.

But now investors can leave the fancy and complex futures trading to the experts, and reap the benefits as commodities rise.

The Pimco Commodity RealReturn Strategy Fund [MUTF: PCRDX] invests in both leveraged and unleveraged commodity-linked index notes to match the return of the commodity futures markets.

The fund also uses other fix-income instruments like treasuries and preferred stocks to increase returns and lower the volatility that is commonly associated with investments in commodities.

Well, there you have it: four great ways to protect your portfolio against the coming inflation wave. In the coming weeks and months we’ll bring you additional ideas in these areas.

Regardless of how you do it, in the current environment, investors need to keep their eyes focused on inflation. And as the global economic engine shifts into higher gears it will likely become an even more significant factor.