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Beat inflation with a balanced funds portfolio

Investors should factor the risk of inflation into their long-term planning
November 24, 2016

Inflation is a risk investors need to plan for as it could be much higher in the UK in 2017 due to rising energy prices and the fall in the pound, which makes imports more expensive. Despite a dip in inflation this month, the Bank of England expects consumer price index (CPI) inflation to peak at 2.7 per cent late next year, up from the current level of 0.9 per cent. US President-elect Donald Trump's pledge to boost infrastructure spending in the US is also likely to drive up inflationary pressures.

But making drastic changes to your portfolio to try to combat rising inflation could leave you out of pocket if it fails to rise as anticipated.

"It is incredibly difficult to predict future rates of inflation," says Patrick Connolly, certified financial planner at Chase de Vere. "Of course, this doesn't stop lots of people from trying. But in 2011, with inflation around 5 per cent, nobody was predicting the lack of inflation that we've seen subsequently, driven in part by the collapse in energy prices. The consensus view now is that weaker sterling, driven by Brexit, will cause inflation. This may happen, but it's not inconceivable that sterling will strengthen again and that inflation will be lower than many predict."

And Adrian Lowcock, investment director at Architas, isn't convinced that rising inflation will be sustained past the end of 2017.

"What's been driving inflation in the UK are temporary things, like the oil price rebounding from $27 to between $40 and $50," says Mr Lowcock. "We don't think that's going to double again from here, so that [contributor] is not going to be there in 12 months' time. Likewise with the pound, which is the other big driver of inflation. It has fallen driving the cost of import but we don't expect the pound to fall another 20 or 30 per cent."

And there does not seem to be any significant wage inflation in the UK.

However, if you want your investments to grow over the long term you still need to take inflation into account, otherwise it will reduce the value of your investments in real terms.

"Inflation can erode the value of your money over time, meaning its buying power will fall," Mr Connolly explains. "The best approach is to hold a balanced and diversified portfolio that includes exposure to shares that can be expected to outperform over the long term, alongside perceived safer assets such as fixed interest and absolute-return funds, which can provide diversification and help manage risk."

Mr Lowcock agrees that investors should not fixate on short-term movements in inflation, but plan for the long term. He says: "Inflation running at 3 per cent will halve the value of your money in 23 years, which sounds like a long time, but halving the value of your money when you're saving for retirement has a big impact so you do need to think about it."

One area Gary Potter, co-head of the F&C multi-manager team at BMO Global Asset Management, thinks investors should be concerned about, is their bond exposure - especially as any rise in inflation will erode the purchasing power of a bond's future cash flow.

"It beggars belief that in some cases government bond markets are yielding next to nothing and in some cases are negative," he says. "That is madness because if inflation is there these yields will need to rise, and when they rise, prices fall and people lose capital. I don't think many people who are invested in bonds and think they're a low risk asset understand that risk of capital loss."

 

How to beat inflation using funds

The fact that developed market bonds are already so expensive adds to the case against them, so Mr Potter has been upping his funds' exposure to emerging market debt via funds such as Ashmore Emerging Market Debt (LU0861576162). He argues that this is a better way of hedging against inflation because it offers a higher yield, which at the moment is 7.87 per cent. His firm recently analysed which asset class performed best over the past 20 years and found it was emerging market bonds.

"You have to accept the volatility you will get from time to time, but if you stay the course you will get paid and well rewarded," he explains. "Despite the reversal of the emerging markets bond market over the past couple of weeks, which is largely currency related [following Donald Trump's US election victory], the yields are attractive."

Mr Lowcock is also cautious about fixed income, including inflation-linked bonds which traditionally have been used to mitigate inflation. The problem, he says, is that markets these days price in changes to inflation expectations very quickly. As a result, for investors to make money with these bonds inflation will need to overshoot already high inflation expectations.

But Colin Low, managing director of Kingsfleet Wealth, says fixed income can still provide a useful diversifier for investors who want to preserve capital if equity markets fall. He incorporates some bond investments in his clients' portfolios, although his firm is starting to reduce this slightly. Overall he prefers lower-duration bond funds, which are less sensitive to interest rate changes and inflation, because the bonds they hold have a shorter maturity.

Another way you can inflation-proof your portfolio is by holding real assets such as property, and infrastructure funds and investment trusts, as their yields are often linked to CPI. However, many infrastructure investment trusts are trading at very high premiums to net asset value (NAV), increasing the risk that you could be overpaying for the inflation-proof security they offer.

"Infrastructure investment trusts look rather attractive," says Mr Lowcock. "Their income stream is very transparent, the tenants are quite often government and you get a good, stable income that's relatively low risk and has a lot of transparency. But that's why these trusts trade at a premium."

Commercial property investment trusts are also a good option for protecting your portfolio against inflation. Like infrastructure investment trusts, property investment trusts benefit from inflation-linking attached to rents, so offer some protection against a rise in inflation.

Mr Low also recommends equity income funds for combating inflation because they offer a potential growing income from high-dividend-paying companies.

Equity income funds are also a good core holding for portfolios. "A sensible choice is UK and overseas equity income funds, especially where the natural income produced is greater than the rate of inflation," says Mr Connolly." Equity income funds can help to spread risks, and provide access to good quality companies that are making regular profits and paying consistent dividends."

But investors should double check they are not getting overexposure to certain shares as many equity income funds hold the same underlying stocks as each other.

Mr Potter, meanwhile, thinks growth-focused companies may be a better bet in future than the defensive, income-producing companies - so called bond proxies - that have been in favour recently. "If we get a reversal in the bond market, which I believe we're starting to see the signs of, with yields going up, then some of these bond proxies may be put under pressure," he explains. "If inflation is in the system, then you want to be in growing companies that have pricing power in their industry and where there's real earnings power [as they] can profit from rising economic activity."

 

Funds for beating inflation

Mr Connolly thinks equity income funds such as Artemis Income (GB00B2PLJJ36) and Aviva Investors UK Equity Income (GB0004460803) are good core holdings and offer inflation-beating returns. Both have yields of around 4 per cent.

"Artemis Income aims to produce a diversified income stream, looking to invest in companies with sustainable and growing cash flows so it can increase income over time, while having relatively low volatility," says Mr Connolly. "Aviva Investors UK Equity Income's manager, meanwhile, adopts a long-term approach, meaning the fund has a low turnover rate and invests in a combination of companies with high barriers to entry, undervalued companies and growth stocks."

For overseas equity income, options include IC Top 100 Fund Newton Global Income (GB00B8BQG486), which is the top-performing Global Equity Income fund over one and three years. Its managers invest in shares that yield at least 25 per cent more than the FTSE World Index to ensure the fund has an attractive yield, and look to exploit macroeconomic themes and pricing anomalies via the companies they invest in. Less than a fifth of its assets are listed in the UK, so it offers geographically diversified exposure.

Mr Connolly suggests Invesco Perpetual Global Equity Income (GB00BJ04H253), which focuses on attractively valued, high-quality companies with strong franchises and balance sheets that offer growing and sustainable dividends. It yields about 3.3 per cent.

Mr Lowcock likes First State Global Listed Infrastructure Fund (GB00B24HK556), also an IC Top 100 Fund, which invests in listed developed market companies. This fund's manager, Peter Meany, typically looks for companies with pricing power operating in areas with high barriers to entry. And because it is an open-ended fund rather than an investment trust, investors do not have the problem of a high premium to NAV.

For fixed income he prefers a cautious, defensive option such as Invesco Perpetual Corporate Bond Fund (GB00BJ04F877). "The managers understand where we are in the business cycle," he says. "They believe it is important to know what economic data is most relevant at any time. The fund currently has a lot of exposure to financials, which should do well in an inflationary and rising interest rate environment."

Mr Low says short-duration bonds are a useful diversifier, so suggests AXA Sterling Credit Short Duration Bond Fund (GB00B5WB6639).

Another inflation-proofing asset that acts as a diversifier to equity holdings is commercial property. "We like investment trusts such as TR Property (TRY), which we've been in for a very long time," says Mr Low. "It's very straightforward, doesn't take big bets on things and you get a bit of inflation-proofing through the rental income."

 

Fund12-month yield (%)1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
Invesco Perpetual Corporate Bond44.5NANA0.61
Artemis Income 46.617.970.90.79
Aviva Investors UK Equity Income 4.16.216.872.70.81
Newton Global Income331.148.70.79
Invesco Perpetual Global Equity Income3.319.0NANA0.87
Ashmore SICAV Emerging Markets Debt7.913.019.31.11
AXA Sterling Credit Short Duration Bond1.72.85.013.70.43
First State Global Listed Infrastructure2.330.851.198.50.82
TR Property Investment Trust (share price)2.9139

115.4

1.14
FTSE All-Share index 11.615.558.0
MSCI AC World Index 27.441.495.7
JPM EMBI Global Diversified Index 32.254.568.7
FTSE Global Core Infra 50/50 Index29.745.591.6
IA £ Corporate Bond sector average7.316.234.0
IA UK Equity Income sector average5.816.966.4
IA Global Equity Income sector average21.228.976.8

Source: Morningstar

Performance data as at 18 November 2016