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How to inflation-protect your portfolio

With inflation rising now maybe a good time to protect your portfolio against it
April 28, 2016

It has been easy to grow complacent about inflation in recent years. The rate of inflation has remained stubbornly low, last year reaching a record low of -0.1 per cent - the first negative figure since 1960, despite the best efforts of central banks to push it up. But in March 2016 UK inflation, as measured by the Consumer Prices Index (CPI), jumped to 0.5 per cent and the rate is now the highest since December 2014.

That means it is now a good time to check whether the value of your investments is protected against inflation erosion. "Price growth was 5.2 per cent year on year back in September 2011, but had slumped to -0.1 per cent last September meaning prices had actually fallen compared with the previous year," says Darius McDermott, managing director of FundCalibre. "And if we do vote to leave the European Union (EU) in the Brexit referendum, sterling is predicted to depreciate considerably. This could cause quite dramatic price rises."

"If we see a reversal in depressed commodity prices, which have all been under pressure, then that could prove inflationary, adds Gavin Haynes, managing director at Whitechurch Securities. "And if Brexit does occur, a short-term weakness in sterling would make everything we import more expensive."

Arguably, the time to buy inflation protection is not when the rate has already risen but while the right assets are still priced fairly: "By the time inflation has arrived the traditional inflation-proofing assets have already priced it in," says Mr Haynes. "So if you are looking to hedge against it then a good time to do so is when not many people are expecting it, and bond markets are pricing in the opposite."

 

Inflation-proof equities

You should choose some UK equity funds with exposure to the kinds of stocks that will do well in an inflationary environment to protect your portfolio. Inflation is particularly tough for companies in price-competitive sectors, which find themselves unable to combat rising costs by raising their own prices. There is a contrast between stocks in cyclical sectors, which are capital-intensive and face fierce competition in brand and price, and stocks that are protected by a healthy cash buffer and command a competitive advantage in their sector.

Mr McDermott suggests Evenlode Income (GB00B40Y5R17), which "invests in some such companies, including Procter & Gamble (PG:NYQ) and Sage (SGE)". The fund has been an impressive performer in the long term, having returned 83.9 per cent over five years. It has a low portfolio turnover and aims to invest in businesses that are able to generate consistent cash flow and sustainable real dividend growth throughout market cycles, and offer a good return on equity. Those businesses tend to be those focused on sectors such as consumer goods, software and specialist engineering, where the products are not vulnerable to a downturn in demand.

Evenlode Income's manager, Hugh Yarrow, says: "We like stocks with pricing power because they are good at insulating you against an inflationary environment, and long-term inflation is always a risk. These are also good in a deflationary environment when demand is low because they tend to sell resilient products."

He says businesses with pricing power include stocks like Unilever (ULVR) and Diageo (DGE). "These are industries that do change quite slowly, but if you sell things like shampoo and beer the risk of technological disruption and displacement is quite low."

Software company Fidessa (FDSA), which sells software to the investment banking sector, is another favoured stock. Mr Yarrow says that because the service is mission critical, the cost of failure is high and switching costs to another brand are also high, meaning Fidessa has a sustainable revenue stream and high barriers to entry.

Jason Hollands, managing director at Tilney Bestinvest, likes Liontrust Special Situations* (GB00B57H4F1): "Its whole process is about finding companies with very resilient characteristics which are cash generative and tend to have high barriers to entry," he says. "Its managers are shy of cyclical businesses which compete on price, and they tend to find businesses with some form of intellectual property, captive distribution or resilient brand, making it inherently inflation-proofed in its approach."

Liontrust Special Situations Fund invests across the FTSE All-Share and top holdings include Relx Group (REL), Unilever, Diageo, GlaxoSmithKline (GSK) and BP (BP.).

"You should look to dividend-producing shares that have a good track record of increasing their dividends, not necessarily the highest yielding shares but those that can show dividend growth and grow income above inflation," adds Mr Haynes. "Examples include Rathbone Income Fund* (GB00BHCQNL68). Its focus is not producing the highest yield, but investing in shares that grow their dividends, and it is this type of fund that might see a short-term shock if we do get an inflationary shock. But over the medium to long term, an equity income fund that can invest in companies that can grow dividends would be a good inflation-proofing investment."

Inflation-proof bond funds

Inflation is bad news for bonds as it erodes the value of the income you receive. Longer-duration bonds are most at risk from this erosion, meaning shorter-dated bonds offer a measure of protection. However the obvious place to take shelter if you are concerned is an index-linked bond fund.

Mr McDermott likes M&G UK Inflation-Linked Corporate Bond GB00B460GC50), which invests in a mixture of index-linked government and corporate bonds.

Unlike a nominal bond, the payment of income on an index-linked bond is tied to an inflation index and means investors are paid a real rate of return. These bonds tend to yield less than longer-dated bonds - M&G UK Inflation linked corporate bond currently yields 0.3 per cent according to Morningstar. It is likely to underperform in a low-inflation environment, when government bonds or other corporate bonds outperform. Its manager, Ben Lord, also uses credit derivatives to take bets on market movements, which can have a negative as well as positive impact on returns.

Mr Lord has been awaiting a return to inflation for the past year and says it is finally happening now. Earlier this month, he said: "Deflation risk in the US and UK is in the past. Core inflation is now back at 1.5 per cent - in Retail Prices Index (RPI) terms - and above 2 per cent in the US, so it's definitely not when, but now about how much."

However, strategic bond funds are often cited as better homes for private investors' money, as managers of these funds are able to move between different bond types and maturities depending on where they see the best opportunities. Strategic bond funds we count among the IC Top 100 Funds include Jupiter Strategic Bond* (GB00B4T6SD53) and Henderson Strategic Bond* (GB00B03TP539).

 

Inflation-proof alternative assets

Real assets such as property and commodities are another way to protect yourself. Infrastructure funds offer a hedge against inflation, as the high yields they throw off are often linked to CPI. These funds can yield upwards of 5 per cent - appealing in a climate of low rates - but do trade on high premiums to net asset value (NAV) as a result. Examples include John Laing Infrastructure (JLIF) and HICL Infrastructure Company* (HICL). Both are trading on double-digit premiums, but offer yields of around 5 per cent.

"The yields on infrastructure vehicles are attractive, but the prices have moved upwards to reflect those strong underlying dividends being chucked off to investors, so it's a difficult call," says Mr Hollands. "Even though it is trading at a premium, John Laing Infrastructure is yielding 5.5 per cent, and the underlying contracts are typically for 20 to 30 years - and in nearly all cases would have annual increments linked to inflation."

Mr Haynes recommends open-ended fund Lazard Global Listed Infrastructure (IE00B5NXD345). "Investment trusts do look expensive and there are opportunities in open-ended funds globally, such as First State Global Listed Infrastructure (GB00B24HJL45)."

This fund invests in a diversified portfolio of infrastructure-related securities from around the world, and is a solid defensive play.

Commodities also provide a hedge against inflation and investors often turn to gold as a way of insuring against rising prices as it does not act in the same way as other assets. ETFS Physical Gold (PHGP), an exchange-traded commodity (ETC), tracks the price of gold by investing in certificates secured by physical gold bullion.

 

The risk of getting it wrong

Your prime risk with taking out inflation protection at the wrong time is one of opportunity cost - missing out on better returns elsewhere and accepting derisory yields, rather than the risk of losing money - especially in bonds.

"M&G UK Inflation Linked Corporate Bond Fund is pretty defensive, so you wouldn't expect it to see significant losses," says Mr Haynes. "But in a deflationary climate it will underperform defensive fixed-interest, in which case high-quality government bonds would be a much better performer."

When it comes to equities, the key risk is overpaying for security. Large global brands with recurrent revenues have been favoured by markets and, as such, many look expensive. But that could be a price worth paying. "Considering whether these stocks are too expensive is a challenge, but there is a reason why they are expensive," says Mr Hollands.

The same is true of infrastructure funds, and particularly trusts where investors face paying high premiums in order to benefit from healthy yields.

Mr Hollands also believes it is still too early to be worried about inflation and argues that investors should not invest temporarily according to inflation trends, but instead maintain a portfolio that offers a real return above inflation at all times.

He says: "I'm not convinced that we need to be worrying about inflation just yet. We are in a benign environment and the figures were unexpectedly high in March, partly because of Easter falling early this year and a strong rally in commodities."

He argues that some of the inflationary pressures acting on markets at the moment could end up being relatively short-term, particularly after talks in Doha between oil producers over a production freeze ending in stalemate pushed down prices again. Of Brexit (the UK leaving the European Union) too, he argues that any central bank move to shore up sterling in the immediate aftermath of a vote could result in lower, not higher inflation, and with so many "moving parts" predicting which way it will go is tricky.

Mr Haynes adds: "We take a long-term core approach where we've got core asset classes and invest across the investment cycle. With the uncertainty you can't have all your investments pointing towards a deflationary or inflationary environment, and you should have investments in both areas."

*IC Top 100 Fund

 

Performance (% cumulative returns) of inflation-proofing funds

Inflation-proof equity funds 1m3m6m1yr3yr5yr10yr
Evenlode Income (GB00B40Y5R17)3.413.79.75.738.583.9
Liontrust Special Situations (GB00B57H4F1)3.010.36.54.233.379.1207.1
Rathbone Income (GB00B3Q9WG18)1.79.22.51.031.468.671.9
Inflation-proof bond funds1m3m6m1yr3yr5yr10yr
M&G UK Inflation-Linked Corporate Bond (GB00B460GC50)1.23.50.6-0.81.810.6 
Jupiter Strategic Bond I Acc (GB00B4T6SD53)0.81.00.9-0.911.533.2
Henderson Strategic Bond I Acc (GB00B03TP539)1.01.91.6-0.212.729.571.6
Inflation-proof alternative assets1m3m6m1yr3yr5yr10yr
John Laing Infrastructure (JLIF) 2.37.55.55.926.852.7
HICL Infrastructure Company (HICL)2.37.26.99.742.880.7158.5
Lazard Global Listed Infrastructure (IE00B5NXD345)
First State Global Listed Infrastructure B Acc (GB00B24HJL45)3.317.914.16.840.074.4 
ETFS Physical Gold (PHGP)1.012.214.28.3-6.1-6.8

Source: FE Analytics, as at 21.04.16