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Think TIPS Will Protect Clients from Inflation?

Think TIPS Will Protect Clients from Inflation?

Plenty of advisors have embraced Treasury Inflation-Protected Securities (TIPS). The principal value of TIPS rises with the consumer price index. That provides important protection at a time when energy prices are high, and many economists worry that Washington’s policies could cause a bout of inflation.

But TIPS are not always reliable. Like all bonds, TIPS can sink when interest rates rise. And the securities can produce disappointing results in market downturns. During the collapse of 2008, panicked investors dumped TIPS. For the year, inflation-protected funds lost 4.1 percent, trailing well behind the CPI, according to Morningstar.

To provide more complete protection against inflation, a dozen companies operate real asset funds. Several have long track records, but most of the funds have opened in the last year or two as financial advisors became more concerned about the risks of inflation. The funds all follow slightly different strategies. Some of the funds forgo TIPS, relying instead on commodities, real estate, and floating rate securities. Other funds include TIPS. No matter what approach they take, portfolio managers agree that it pays to hold several kinds of assets. “By diversifying, you get lower volatility and better results than if you hold just one asset class,” says Joanna Bewick, portfolio manager of Fidelity Strategic Real Return (Ticker: FSRRX).

For diversification, the Fidelity fund keeps about 30 percent of assets in TIPS, 25 percent in floating-rate securities, 25 percent in commodities, and 20 percent in real estate. Fidelity portfolio managers arrived at the mix by comparing how different assets had performed relative to the CPI going back to 1973. TIPS proved to be the most consistent performer, outdoing the CPI in 79 percent of rolling 12-month periods. Floating-rate debt also shined with a hit rate of 79 percent. Real estate won 70 percent of the time, while a diversified basket of commodities had a success rate of 67 percent. Gold proved disappointing, only outdoing the CPI 54 percent of the time. Fidelity’s researchers discovered that the different asset classes did not all move in unison. Sometimes real estate rose, while commodities fell.

The Fidelity fund began operating in 2005, and so far the results have been on target. During the five years ending in February, the fund returned 3.6 percent annually, outpacing inflation by a comfortable margin.

Saying No to TIPS

Cohen & Steers Real Assets (Ticker: RAPAX), a new fund, takes a different approach. While the portfolio has about half its assets in commodities and REITs, the rest is in natural resources equities, gold, and short-term bonds. There are no TIPS.

Cohen & Steers portfolio manager Yigal Jhirad argues that TIPS have proved disappointing since they were introduced in 1998. During periods of rising inflation, TIPS have returned 8.4 percent annually. That may sound like a decent result, but other assets have done better. Natural resources equities returned 12.4 percent, while REITs gained 10.7 percent.

Part of the problem with TIPS is that they are tied to the CPI, which is an imperfect measure of inflation. Over the years, the Bureau of Labor Statistics has changed the way that CPI is calculated, and the revisions have lowered the inflation rate. This is not an accident, says Jhirad, because a smaller CPI lowers the government’s cost for inflation-adjusted payments, such as Social Security. The official CPI is only about half the rate that many consumers experience, he says. While the CPI rose 28 percent in the last decade, medical costs climbed 46 percent and gasoline rose 190 percent.”The CPI is supposed to track the costs of the average consumer, but not many people are average,” says Jhirad.

In the future, the returns of TIPS could come under pressure. If interest rates rise in coming years, as many economists expect, TIPS would suffer along with all government bonds. Even if rates don’t climb, TIPS could deliver poor returns in the future because the current prices are rich. Worried about uncertain markets, investors have bid up all government bonds, including TIPS. Prices have gotten so high that 10-year TIPS have negative yields, suggesting that the bonds could return less than the CPI.

Jhirad says that REITs and commodities complement each other because they don’t rise in unison. As inflation rises, commodities tend to soar. REITs climb—but not as fast as commodities. When inflation eases, commodities tend to sink, while REITs can continue delivering healthy results. Sometimes commodities and REITs move in opposite directions. During the late 1980s and early 1990s, real estate stagnated because of oversupplies. But commodities climbed through much of the period because of growing demand and tension in the Middle East.

Besides REITS and TIPS, Principal Diversified Real Asset (Ticker: PRDAX) has 10 percent of assets in pipeline master limited partnerships. Portfolio manager Mike Finnegan says that pipelines can offer secure income that rises with inflation. MLPs typically build an oil or gas pipeline and then charge energy companies to use it. Under federal rules, the pipelines cannot charge more as energy prices rise. Instead regulators permit MLPs to raise prices at the inflation rate. Finnegan says that income is secure because many pipelines enjoy monopolies. “Once you get permission from state and local governments to build a pipeline, you don’t have to worry that someone will build right next to you,” says Finnegan.

American Century Strategic Inflation Opportunities (ASIDX) keeps about 25 percent of assets in commodities, including natural resources stocks and ETFs that track commodity benchmarks. Portfolio manager William Martin says that he uses the two kinds of holdings because they have different characteristics. During some months, resources stocks deliver better performance, and other times the ETFs jump into the lead. While the resources stocks sometimes have a high correlation with the S&P 500, the commodities ETFs—which use futures to track benchmarks—have little correlation with stocks.

The futures ETFs provide particularly good protection during price shocks that can come after political problems or natural disasters push up prices. But futures markets can be fickle. In recent years, there have been times when commodity ETFs lost money, even though prices of oil and other assets were climbing. By holding a variety of different commodity investments, American Century aims to deliver relatively steady results.

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