An article in the May 18 NYT reviewed investors’ options for insulating a portfolio from the effects of inflation but it contained a number of inaccuracies, some of which I will review below
May 18, 2008
How to Stop Inflation From Devouring a Portfolio
By J. ALEX TARQUINIO
Is inflation roaring back with a vengeance? It depends on whom you ask.
“The experience we have had in recent years harks back to the 1970s,” when commodities prices surged, said Zvi Bodie, a professor of finance and economics at the Boston University School of Management. He recommends that investors reposition their bond portfolios, in particular, to try to minimize the ravages of inflation.
The above contains some good and some not so good advice. First off, making changes in a bond portfolio based on a forecast for inflation, just like any other type of market timing is usually a poor move. On the other hand, Prof. Bodie’s suggestion that bond portfolios be positioned to protect against inflation is good advice indeed. And it makes sense in a long term allocation regardless of one’s current economic forecast.
But some strategists say the weak economy may help moderate inflation later this year. “What is holding inflation down, even to this elevated level, is the sluggish economy,” said Stuart A. Schweitzer, the global markets strategist at JPMorgan Private Bank. “And I think growth is likely to stay quite sluggish all this year, in which case inflation should come back down.”
The above is simply an economic forecast, a thin reed to hang an investment strategy on.
In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.
I would label the above statement extremely imprecise if not just plain wrong. In fact there is an investment that would shield retirees from inflation’s ravages. Certainly it provides protection that is even better than the inflation adjustment to social security or most private pensions.
The instrument is TIPS: Treasury Inflation Protected Bonds. These bonds pay a fixed rate (the real return) in addition to an inflation adjustment based on the govts consumer price index (CPI U) thus the bonds return is guaranteed to keep up with the CPI plus pay an addition real return. So an investor holding these bonds would receive a current return based on the CPI (3.9%) + the real return of (currently 1.5% for the ten year bond) That is attractive relative to social security which adjusts to the CPI and most inflation protected pensions which are similarly adjusted. By comparison the current conventional 10 year Treasury bond pays 3.84% with of course, no inflation adjustment. On this bond your interest does not even cover inflation. In economist’s lingo there is “negative real return”.
For bond investors the great enemy is inflation particularly when it creates a situation such as we have presently for treasury bonds: a negative real return. In many ways TIPS are the “perfect” fixed income investment. Even if they do not completely replace conventional bonds in a portfolio they certainly merit a significant allocation. The bonds can easily be bought in low cost mutual funds or etfs.
In my view Professor Bodie is quite right later in the article:
…. Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds’ principal based on changes in the Consumer Price Index.
In fact, he said he would not personally own any bonds now that did not adjust for inflation. “I don’t have to guess with TIPS,” he said. “I can lock that inflation-adjusted return in today.”
Professor Bodie is a major advocate for very large holdings of TIPS in investors’ portfolios in a recent book Worry Free Investing.
As noted below, TIPs have recently had a large runup in price pushing the real yield to historically low levels. While this may not be the best instant to buy TIPs it doesn’t do much to diminish their long term attractiveness.
Compared to the long term argument in favor of TIPs based on the structure of the instrument the comments of JP Morgan’s Mr. Schweitzer seem relatively flimsy
.
Schweitzer pointed out that inflation-protected bonds have already had a very good run. The Morningstar category for inflation-protected bond funds shows that they have returned 11.5 percent, on average, in the last 12 months. Although these bonds may be good for capital preservation, Mr. Schweitzer said that their current rich prices might mean that they will generate disappointing returns in the coming years — unless, of course, the economy is entering a long period of high inflation.
Mr. Schweitzer definitely shows his colors as a two handed economist as he argues inflation protected bonds (tips) may not be a good investment going forward…..or maybe they will.
Another often touted strategy to protect a portfolio is to invest in commodities, particularly gold. The growth of efts and etns (exchange traded notes) tied to individual commodities such as gold,silver and oil or commodity indices has made it far easier to invest in commodities. While it is true that commodities generally rise with inflation. This hedge is certainly not perfect.
Several fund companies have begun offering “real return” strategies in mutual funds that invest in TIPs. Commodities and real estate in with the goal of beating inflation. One major fund company (Fidelity) has a full page ad in the same Sunday issue of the NYT (could that be mere coincidence) for a “strategic real return fund…”that’s designed to outpace inflation”. The fund has only been in existence since September 2005 but the results do not seem particularly encouraging: a return of 4.83 through the end of the first quarter vs. 11.54% for the vanguard inflation protected bond fund. There is a longer track record for another real return fund: The PIMCO Real Return Asset fund. Its one year return is 12.83. The fund ’s 5 year return is 8.14% vs. the vanguard inflation protected bond fund’s 6.27%. But that return comes at considerably more risk: the volatility (as measured by standard deviation ) of the Pimco fund is 8.43 vs. Vanguard’s 5.03.
While it is true that the two asset classes that consistently are positively correlated with inflation are TIPs and commodities, it would probably serve and investor to purchase these two asset classes directly and at lower cost than by purchasing the active managed “real return fund. As is usually the case with an actively managed fund one the investor is paying a higher management fee and is counting on the active manager who will be actively switching between holdings of commodities, tips, real estate and conventional bonds. The PIMCO fund must be altering its strategy at a rapid rate, its portfolio turnover is 489% (!)
Current market conditions for those trying to add inflation protection to their portfolios are difficult. They are a bit late to the party as commodities have increased sharply in value and have been particularly volatile. The real yields on TIPS are at historically low yields a consequence of high inflation expectations and low yields on conventional treasuries. Nonetheless the TIPs are surely more attractive than the conventional treasuries.
Prof Bodie is not far from the mark in stating:
“The bottom line is there is no free lunch,” he said. “If you try to protect yourself against inflation with either or both of these approaches, then you have to either give up return,” by accepting the lower yields that are now available on TIPS, “or take on more risk” in the commodity markets.
His advice certainly makes more sense than this:
“If you are looking to outpace inflation, you should be investing in stocks,” said Sam Stovall, the chief investment strategist at Standard & Poor’s.
For the moment, Mr. Stovall recommends underweighting bonds while maintaining a neutral position on stocks.
The above strategy points out the difference between a long term strategy and a trading orientation. Only 2 asset classes: TIPs and commodities have a long term positive correlation with inflation (i.e. they move up with inflation). US stocks have a negative correlation.
Here’s more of Stovall’s advice :, if an investor keeps 60 percent of her total portfolio in stocks, he might advise that she keep 25 percent of the total in bonds and 15 percent in cash. His usual recommendation would have been to put 30 percent of the portfolio in bonds and just 10 percent in cash.
This”strategy" has nothing to do with a structured strategy to offset inflation as can be seen by the lack of any mention of TIPs in the bond portion of the portfolio.
Moreover, Mr. Stovall said that once investors felt comfortable enough to put more money into the markets, they should buy stocks rather than bonds.
And here is another market guru, ostensibly an expert on inflation and investing who makes a market call rather than recommending a strategy for limiting inflation’s hit on a portfolio.
Jim Floyd, a senior analyst …, who edits Inflation Watch, a monthly newsletter for Leuthold, said he was most concerned about sky-high commodity prices.
Mr. Floyd recommended taking a fresh look at some stocks that have suffered recently. He said that there might be opportunities in consumer products, utilities and financials, including insurance companies, banks and real estate investment trusts. “You want to buy the companies that are beaten down before the good news comes out,” he said.
Another analyst who I generally hold in high regard reaches a conclusion which I find puzzling
Ed Yardeni, the president of Yardeni Research, based in Great Neck, N.Y., said he thought that commodity prices could have further to run. He cited rising demand in developing nations like China and India, combined with dwindling discoveries of raw materials that are relatively easy to extract.
But he warned individual investors against buying commodities, for example, through one of the scores of commodity exchange-traded funds that have sprouted in recent years. Commodity prices are so volatile, he said, that individual investors who bought them would probably not sleep too well at night.
Instead, he advised investors to take a page from the San Francisco gold rush.
If you are an investor who thinks that the commodity boom is far from over, he said, “don’t get yourself dirty digging for gold; open up a shop that sells picks and shovels.”
He said that such “pick-and-shovel” stocks include shares of oil-field services companies, specialty chemical manufacturers, fertilizer makers and other companies that provide the materials or services on which the mining and agricultural industries rely.
I’m not sure I understand all the logic here. Yes commodities can be volatile, but Mr. Yardeni thinks they are likely to go higher. That would seem to me to argue to hold a relatively small allocation in commodities and to rebalance on an ongoing basis, reducing the position and consequently reducing risk on big increases in price and adding on price drops.
The pick and shovel companies he describes might be interesting for stock pickers, but there certainly is more risk that they will disappoint as inflation hedges compared with directly buying an etf based on a basket of commodities. Any number of factors independent of commodity prices could affect the returns of these stocks.
In sum, it seems the best strategy to add some inflation protection to a portfolio is the same as it is for most asset classes: keep the portfolio balanced and invest in instruments that have low costs and transparency and are invested directly in the asset class. In the this case it would be a low cost inflation protected securities fund or etf and a low cost commodity index exchange traded fund or note.
No comments:
Post a Comment