Consumers around the world are all too familiar with inflation by now.
More than two years into the pandemic, companies are contending with supply chain disruptions, which are affecting manufacturing and production timelines and costs. The Russia-Ukraine war has been a contributing factor, driving food and gas prices higher, and will continue to put pressure on the cost of goods and services as long as consumer demand persists.
With inflation expected to stay elevated throughout the year, the Federal Reserve is taking a more aggressive stance to tighten monetary policy by moving to increase interest rates and tame the sustained rise in prices. The Fed raised the interest rate for the fourth time this year in July, representing the largest streak of sudden rate hikes since the 1990s. And Powell’s remarks Aug. 26 from the Fed summit in Jackson Hole, Wyoming, indicated that a large rate hike is still on the table for its next policy meeting in September.
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Investors should address inflation’s effects on their portfolios because if they don’t, it can erode their purchasing power and cut into their returns.
“Inflation is always a long-term factor for investors to include in their strategy, in particular monitoring their real return,” says Ryan Shuchman, investment advisor and partner at Cornerstone Financial Services. Real return is the return on the investments minus the level of inflation.
If a bond investor realizes a 4% return, and inflation is 6%, the purchasing power of your investment principal actually declined, Shuchman says. “So, investments that hedge against inflation must be considered and included in a portfolio.”
Here are some asset classes that can help with that:
— Commodities.
— Equities.
— Treasury inflation-protected securities.
— Infrastructure.
Commodities
Commodities are often the first asset class investors think of when looking for inflation hedges. These are raw materials including oil, natural gas, precious metals, wheat and corn. They can be traded on the futures market, where parties agree to buy or sell commodities at a certain time, and for a certain price, in the future. You can also purchase commodity exchange-traded funds, or ETFs, or commodity stocks.
In fact, commodities act as a natural hedge against inflation. As commodity prices increase to help drive inflation in consumer goods, commodity investors can get a good return on those investments.
The trouble with commodities as an inflation hedge is that they come with a “tremendous amount of volatility,” says Ted Wozniak, U.S. head of asset management distribution for SEI. In fact, commodity prices can fluctuate with changes in demand, the dollar’s strength overseas and natural disasters.
Given that there is some volatility tied to the commodities market, experts recommend investing in commodities through a diversified investment vehicle, such as a mutual fund or ETF.
Gold has historically been a popular commodity for protecting your investment portfolio against inflation. Since gold prices tend to coincide with inflation, by investing in gold, you have a better chance of strengthening your purchasing power on potential investment returns.
But since there is no way to know which commodity is going to outperform year to year, it’s important to diversify.
Commodities are also less effective at protecting against long-term inflation because while commodity prices may soar during high inflation, once the inflation rate begins to subside, those prices could fall fast.
Equities
For a longer-term hedge against inflation, there may be no better investment than equities. Since 1927, equity prices have grown substantially higher than inflation on a real return basis, Shuchman says.
This is possible because corporate earnings tend to grow faster than inflation, says Jas Thandi, partner of Portfolio Strategy at Aon.
If you’re concerned about inflation, consider skewing your portfolio to a higher percentage of equities, especially dividend equities.
“High inflation causes uncertainty in the markets, and uncertainty can lead to prices of equities trading down or flat,” Shuchman says. “When hedging against inflation, dividend equities provide a quarterly return to counteract inflation, via dividends, whether the market is up, down or flat.”
He points to the ProShares S&P 500 Dividend Aristocrats ETF (ticker: NOBL) as a good option for a diversified, dividend-equity-focused investment that can serve as a core inflation hedge in your portfolio.
Treasury Inflation-Protected Securities
Treasury inflation-protected securities, or TIPS, are investments that account for inflation. More specifically, they’re bonds with a principal value that rises (and falls) along with consumer prices. They pay interest twice a year at a fixed rate, which is applied to the adjusted principal. Because they are applied to the adjusted principal, the interest payments also increase with inflation and decrease with deflation.
The difference between the rate of inflation and the nominal interest rate is your real rate of return. TIPS are worth buying if the return on investments minus inflation yields a positive return.
Even though TIPS are a well-known inflation hedge, because their yields are so low, they may not be as appealing as some alternatives. The solution: You don’t have to choose just one inflation hedge; you can diversify the inflation-protected securities in your portfolio.
TIPS are issued at either five-, 10- or 30-year terms. At maturity, investors either receive the adjusted principal or the original principal. If you choose to sell TIPS before they mature, there is a possibility that you could get back less than you initially invested.
If you want to diversify your portfolio to account for inflation during an inflationary environment, TIPS can yield more than conventional bonds. You can buy TIPS through the Treasury website or from your brokerage.
One concern may be that if inflation is lower than expected, the return on conventional bonds may be better. Experts say that if interest rates don’t increase, it could be a good time to move out of TIPS.
Infrastructure
“Today, the concern around inflation is what it means for interest rates and bond yields,” Thandi says. “In the year so far both of these have moved up rapidly, causing a large re-pricing in asset markets, and causing both equities and bonds to lose value at the same time.”
This puts investors in a difficult position because if inflation continues to rise, the effect could become worse and further erode portfolio values.
For this reason, he says the best approach to inflation hedging in the current environment is to use assets that have low correlations to equities and bonds. One such asset class is infrastructure, or assets such as roads, bridges, ports and airports.
“These generate inflation-linked cash flows and cash flows linked to the real economy,” Thandi says. “Therefore, their asset values and cash flows tend to be sensitive to inflation. This can occur through direct mechanisms like toll roads, and exposure to energy infrastructure assets such as power generation.”
Infrastructure has the added bonus of being non-cyclical because these assets are crucial to economic development. Even during economic downturns, people need to use roads and bridges, so investment in infrastructure will remain relatively stable throughout the economic cycle. And with the cash infusion infrastructure will receive from the $1 trillion spending bill passed in November 2021, there are plenty of road and bridge projects that are about to benefit.
Exchange-traded funds are one way for retail investors to gain access to infrastructure projects. For example, the iShares U.S. Infrastructure ETF (IFRA) has gained nearly 2% so far this year as of Aug. 25, while the S&P 500 has fallen nearly 12%. Also outperforming the S&P this year is Global X US Infrastructure Development ETF (PAVE), with holdings such as steelmaker Nucor Corp. (NUE) and machinery giant Deere & Co. (DE). PAVE has about $4 billion in assets under management and a well-diversified portfolio.
Takeaway
Inflation is a fact of life for all long-term investors. “From an investment point of view, inflation protection should be considered like any good insurance policy: You always own it even when you don’t need it,” Wozniak says. “You certainly wouldn’t buy fire insurance after your home has been lost, nor should you wait to own inflation protection.”
The right inflation hedge and amount to include in your portfolio will depend on your risk exposure to inflation and time horizon.
If you’re questioning which inflation hedge is right for you, the best approach may be a diversified one. For instance, SEI incorporates TIPS, equities and various commodity approaches to protect against food and energy price increases.
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Best Investments to Hedge Against Inflation originally appeared on usnews.com
Update 08/26/22: This story was published at an earlier date and has been updated with new information.
