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An inflation-proof portfolio

Created:

24 November 2009

Written by:

Maike Currie

Over the past year or so, deflation has been top of the agenda for central banks and governments worldwide, with fears of a fall in the amount of money and credit available resulting in ultra-low interest rates and unparalleled money-printing, in the form of quantitative easing (QE). This is all very well while the economy is weak. But what happens when it starts to recover?

One worrying possibility is that inflation surges - and inflation erodes the future value of wealth. Robert Pemberton, investment director for wealth manager HFM Columbus, says that even moderate inflation can badly damage savings over the long term. "An (annual) inflation rate of 3 per cent would reduce the purchasing power of £100,000 to just £55,368 over 20 years and a higher rate of 5 per cent could reduce this to a mere £37,689. Even over fairly short time periods, inflation can do a lot of damage to your wealth - an inflation rate of 5 per cent could see the purchasing power of that same £100,000 be reduced to £78,353 in just five years," he says.

No one knows exactly when or even if inflation will flare up, however, most analysts are adamant that the genie will eventually escape from its bottle, and once it starts to take hold, it can rise very sharply. Now might be an opportune time to start thinking about how to put together a portfolio of assets which should positively benefit from having some inflation back in the system. But be careful, as Mr Pemberton says: "Inflation has its own cycle and assets that benefit from a 'little bit' of inflation may be badly hurt when inflation starts to get out of control."

Go index-linked

Inflation is the great enemy of any fixed-interest investment, but before you purge your portfolio of bonds, consider index-linked investments, which rise in line with a specific inflation index.

Inflation-linked gilts will see both the interest payments and the final redemption value rise in line with the retail price index (RPI). A simple way to invest is via a fixed-income exchange-traded fund (ETF) such as the iShares GBP Index Linked Gilts.

Another pure play on inflation is the National Savings & Investments (NS&I) index-linked certificates, for which the current issue has a tax-free interest yield of RPI, plus 1 per cent for both the three- and five-year issues, with investment limited to £15,000 per issue. "NS&I index-linked savings certificates are risk-free, tax-free and provide a guaranteed real return over inflation, and they can be cashed in at any time, although you'll lose some interest if you do so in the first year," says Jason Butler of Bloomsbury Financial Planning.

Alternatively, you could look towards an index-linked global securities fund such as the Standard Life Global Index Linked Bond fund, which invests in a range of government and investment-grade bonds worldwide. Payments are linked to inflation levels in the country of issue, and while it is not risk-free, it does offer the potential for greater index-linked returns than the NS&I product.

Stick to real assets

"Conventional wisdom has it that 'hard assets' such as gold, commodities and property do much better in inflationary times than 'paper assets' such as stocks and bonds. While this was true in the hyper-inflationary 1970s, the evidence has been less compelling since. Thus, you will want some exposure to these assets, but don't bet the farm on it," says Mr Pemberton.

Industrial metal and agricultural commodities typically appreciate when inflation is rising because the economy is expanding and so to the demand for raw materials. Special types of exchange-traded notes (ETNs) such as exchange-traded certificates and exchange-traded commodities (ETCs) can provide you with exposure to physical commodities or commodity indices. While not funds, ETNs share several characteristics to ETFs in that both are linked to the return of a benchmark index and trade on an exchange. But tread carefully; while some ETCs are backed by physical commodities, others are linked to futures contracts, which means their prices may not necessarily track the spot price you see published daily in newspapers.

A simple way to benefit from rising commodity prices would be through a fund of mining shares and resource companies such as the JP Morgan Natural Resources Fund, managed by sector veteran Ian Henderson.

Property is another 'real asset' that produces an income stream, as well as offering capital growth potential. There are many different ways of investing in property and it is important to differentiate between property securities and physical 'bricks and mortar' funds and to appreciate whether or not the investment vehicle uses leverage which will magnify gains and losses. The simplest way to invest in property is through unleveraged daily dealt 'bricks and mortar' fund such as SWIP Property Trust or the M&G Property Portfolio.

Don't discard equities

Standard economic theory says inflation is bad for equities, because it leads to higher interest rates, increased costs and slower consumer demand. But as Mr Pemberton notes: "This is true for rampant inflation at the end of a cycle, but we are currently many moons away from this. Some inflation would be an indication that the economy is moving again and, in practice, is good for stocks as long as you buy the right ones."

Stocks to avoid are those hurt by high interest rates, either because the balance sheet is heavily indebted or because of the effect on consumer demand. In contrast, many of the beneficiary companies tend to be those that pay high dividends and are typically found in equity income fund portfolios, which pay out income yields typically above RPI. "Funds we recommend include Invesco Perpetual Income and Artemis Income. Given that one of the drivers of inflation could potentially be weak sterling, Ignis Argonaut European Income is a sensible option as it diversifies currency risk, as well as meeting the other criteria," says Mr Pemberton.

Go for gold, but be careful

Gold's ability to preserve purchasing power in an inflationary environment enables it to act as a hedge against inflation and currency weakness. In the past, holding gold would have entailed buying small bars or coins, however, investors now have a range of attractive gold investment vehicles to choose from.

You can invest in gold via a fund which invests in shares of gold mining companies such as the BlackRock Gold and General or Investec Global Gold Fund. Alternatively, an exchange-traded fund that is backed by physical gold bullion, such as ETFS Physical Gold, will allow you to track the spot price of gold minus a management fee.

But some warn that UK investors are taking an unnecessary bet on the US dollar/sterling exchange rate by investing in gold through a vehicle which does not provide a currency hedge.

Mr Pemberton also warns investors who tend to see gold as a 'no brainer' hedge against inflation. He says while this is probably true in the case of rampant inflation, as seen in the 1970s, it may not necessarily be the case in a gently rising inflationary environment. "It is the 'sleeper' hedge in case inflation really gets out of control with interest rates rising very sharply and hurting stock, as well as fixed-income returns."

Source: Robert Pemberton, HFM Columbus