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Girding for Inflation: Weathering the Inflationary Cycle

Anyone who's bought gas, paid a medical bill or sent a child off to college recently knows that the Consumer Price Index doesn't tell the whole story of inflation.

Indeed, says Robert DeHollander, an advisor with DeHollander & Janse Financial Group in Greenville, S.C., "We think we're already in an inflationary cycle." He cites the massive amount of global debt issued in the wake of the 2008 financial crisis as the reason he expects prices to rise sharply.

Many others are not as worried. "There's still a lot of excess capacity in the economy," counters Kevin Worthley, a planner with the Retirement Planning Co. in Warwick, R.I. "Inflation may not be at our doorstep just yet."

Whether you think inflation is here now or is headed our way, planners should prepare for it. Even at an annual rate of 4.5% - the inflation level when President Richard Nixon imposed wage and price controls in August 1971 - prices would double in roughly 16 years.



That can be devastating to clients, especially those in retirement. "My focus is protecting the purchasing power of their assets," says Jonathan Winter of Financial Network Investment in Gardena, Calif. To do that, Winter uses commodities, high-yield bonds, TIPS and global fixed-income instruments in local currencies.

Other advisors include real estate and select equities as part of their inflation-hedge toolkit. When it comes to offsetting runaway prices, no asset class gets more attention than commodities. Historically, commodities have had little correlation to the overall equity market. As real assets, they afford inflation protection.

"There is a value to a bushel of corn that is not tied to any dollar value. That value is it can fill X number of stomachs," observes Abraham Bailin, an analyst at Morningstar who tracks commodity ETFs. "It doesn't matter how many dollars we print or take off the market, that will never change."

Commodities are widely seen as an economic canary in a coal mine. "The very first place inflation always shows up is in commodities," says Bryan Beatty, a financial planner at Egan Berger & Weiner in Vienna, Va. But they aren't a panacea for inflation, he adds. When prices rise so high that they choke the economy, commodity bull markets can end abruptly. "They can easily collapse if that inflation causes a recession," Beatty says.

Even when hard asset prices rise, the instruments designed to profit from them can fall. West Texas Intermediate crude oil has risen about 31% since April 2006 when United States Oil Fund (USO), an ETF designed to track it, was launched. Yet the fund has lost more than 41% of its value since then. "If you're taking losses, it's not the fund's fault," Bailin says.

The fund is designed to track the front-month futures contract (and does so almost perfectly). For investors, expiring contracts converge with spot prices. Futures usually are more expensive because people expect higher commodity prices. When the fund rolls over to the next contract, it pays a higher price than it received for the expiring one, a market condition called contango.

So why would anyone buy an ETF that invests in front-month contracts? Bailin says that they have the greatest sensitivity to spot prices. If spot rises, the front-month contract will move higher than longer-dated futures. That means ETFs such as USO are much better suited for speculators than long-term investors.



Some ETFs have sought to mitigate contango using a series of contract expirations. Others employ an algorithm that is designed to predict the best futures contracts to buy. An example is the PowerShares DB Commodity Index Tracking Fund (DBC), which follows a Deutsche Bank index of 14 commodities. It has grown to be the largest ETF in the commodities space.

PIMCO Commodity Real Return (PCRIX), an open-end mutual fund with more than $21 billion in assets, dwarfs the competition. Although volatile, the fund has a positive five-year annualized return. But it also tracks a broad commodities benchmark, the Dow Jones-UBS Commodity Total Return Index, not with futures, but with derivatives. The fund's managers try to outperform the index by trading the collateral, mostly TIPS, underpinning the fund.

Newer funds have been established to buy and sell futures, and most have had mixed results. Active management, whether in commodities, equities or fixed income, "has actually done very poorly," Bailin says.

Cohen & Steers, known to most advisors as a REIT fund manager, takes a somewhat different approach. The company recently launched its Real Assets Fund (RAPAX). The new portfolio combines commodities with REITs, natural resource equities, gold and fixed income.

"I think you're better served by having a mix of assets that do well in inflationary times, but provide diversification across economic cycles," says Yigal Jhirad, senior vice president and portfolio manager of the new fund. Gresham Investment Management controls the commodities portion, and London-based Investec has the natural resource equities allocation of the fund.



Jhirad says active management allows his fund to pick between Brent Crude and WTI, depending on which looks more attractive, while an index is stuck with one benchmark. "That's where a lot of the added value is," he adds.

In April, State Street Global Advisors launched an actively managed ETF that attempts to add value in a different way. The SPDR SSgA Multi-Asset Real Return ETF (RLY) is a fund of funds that owns underlying ETFs tracking inflation-protected securities, real estate, commodities and natural resources. Asset allocations will be adjusted as market conditions change. Managers may have to add value because hard assets are now more correlated with other investments. "Recently, correlation between the broad equity market and virtually every other asset class, barring gold and Treasuries, has increased," Bailin notes.

DeHollander says he has attempted to stay a step ahead by adding managed futures. But managed futures can be an expensive alternative because commodity-trading advisors often charge fees of 2%, plus 20% of profits.

Less costly alternatives are actively managed funds that come under the 1940 Act. Beatty says he has moved to such funds from static ETFs because of the market exaggerations caused by traders buying and selling gold and energy. "We don't want the distortion caused by crowded speculative trades," he says.

That's the kind of reaction Cohen & Steers is counting on to boost sales of its new fund. But for planners who don't want a turnkey hard asset fund, there are funds and ETFs that track various inflation-hedging assets. Advisors can use them to assemble customized client portfolios as needed. DeHollander's firm has long included REITs in client portfolios, even though their "share prices were dinged pretty badly in the last couple of years."

He still likes the group, especially for clients putting new money in. "It's a lousy time to be a seller of real estate, but a great time to be a buyer," he says.



Worthley also favors REITs because rents "tend to rise with inflation." But he is cautious about quality, preferring portfolios of commercial buildings with corporate tenants who have "triple net" leases under which the tenant shoulders the burden of cost increases. Although paying up for quality usually means lower yields, Worthley likes the trade-off. "In this environment, choosing quality over yield might be a better idea," he says.

In the fixed-income area, relatively strong foreign currency debt (including many emerging markets) can provide better yields than those available from U.S. Treasuries. There's another plus, Winter says: "You help protect the client against the falling dollar." Winter also likes TIPS, even though he recognizes their limitations. "I wouldn't take out TIPS just because they're based upon the CPI," he says.

Beatty agrees. "They're not going to reflect true inflation, but they'll at least catch the CPI," he adds. Even common equities can provide inflation protection. They are, Beatty says, "the No. 1 investment to have against inflation." As long as inflation stays moderate, he adds, companies can pass along higher costs.

"A mutual fund or an ETF that focuses on large, diversified energy companies that pay dividends is probably not a bad choice," Worthley says. They even can outpace commodities. In fact, from the end of 1994 through last year, energy-related equities, as represented by the S&P Energy Index, had a greater return with lower volatility than energy commodities represented by the S&P GSCI Energy Index.

Many advisors have boosted client exposure to inflation hedges as global central banks expanded liquidity in the wake of the financial crisis. Once the portfolios are positioned to withstand inflation, though, the waiting begins. Inflation could be ignited by a military confrontation between Israel and Iran, or by something as benign as a solid economic recovery.

"There's plenty of tinder," Beatty says. "All we're missing is the spark."



Joseph Lisanti, a Financial Planning contributing writer, is a New York writer and former editor-in-chief of Standard & Poor's weekly investment advisory newsletter, The Outlook.

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