Ways to inflation-proof your mutual fund portfolio

AP News
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Posted: Feb 24, 2011 10:53 AM
Ways to inflation-proof your mutual fund portfolio

Warnings of high inflation ahead have been around so long it's easy for investors to take them for granted.

Heavy government spending was supposed to have driven inflation sharply upward. Some experts predicted it would hit 8 percent by now.

So far, inflation is still tame.

However, the long era of low inflation likely is nearing an end. Prices have accelerated abroad due to super-heated economic growth in China, Brazil, India and other emerging markets. The U.S. consumer price index has risen by 0.4 percent in each of the last two months, too, increasing prospects that we will eventually have significantly higher inflation at home. Over the past year the index has risen 1.6 percent.

"Investors ignore inflation at their own peril," says Christine Benz, director of personal finance at Morningstar Inc.

Even those who normally leave their mutual funds on auto-pilot would be well-advised to consider inflation-proofing their portfolios.

Ways to protect yourself include overhauling your mix of funds, paring back on riskier international funds and adding offerings that focus on inflation-protected bonds such as Treasury Inflation-Protected Securities (TIPS) _ a type of Treasury bond whose payout is adjusted every six months for inflation. Investing in commodities funds and dividend mutual funds also may help.

Benz discussed the options and best moves for individual investors in an interview with The Associated Press. Here are excerpts:

Q: Why can't investors rely on fund managers to mitigate the effects of inflation?

A: Not many managers spend a lot of time thinking about the macroeconomic environment, whether it's inflationary, deflationary, recessionary or whatever. Instead, most hew to a specific style (such as growth, value, small cap, large cap). For example, it's not typical for most core bond funds to buy TIPS. That means that investors who want to ensure that their portfolios have insulation against inflation should take steps to put it in place themselves.

Q: There aren't any mutual funds composed of I-bonds _ inflation-linked government savings bonds _ so isn't it better for inflation-wary investors to invest in TIPS?

A: Both TIPS and I-bonds are fine options.

I-bonds make good sense for investors' taxable accounts in that they won't owe federal income taxes from year to year _ only when the bond matures or they sell. But with TIPS, investors are not limited to purchases of $10,000 per year as they are with I-bonds. By buying a TIPS fund you also get the advantage of professional management.

For plain-vanilla, low-cost possibilities, both the conventional mutual fund Vanguard Inflation-Protected Securities (VIPSX) and iShares Barclays TIPS Bond (TIP), an ETF, are solid. For an actively managed fund, investors might consider PIMCO Real Return (PRTNX) or Harbor Real Return (HARRX). For investors concerned that inflation is a global phenomenon, our analysts also like the exchange-traded fund SPDR DB International Government Inflation-Protected Bond (WIP).

Q: How effective are commodities in fighting inflation?

A: In theory, buying an investment that tracks commodities prices is a good way to hedge against inflation. As you're paying higher prices for food, gas, and other stuff you need, an investment in commodities should also be going up, helping offset those higher costs.

Unfortunately, the best way to obtain pure exposure to commodities is to take physical delivery of the stuff _ whether it's pork bellies, cotton or oil _ and that's simply not practical for mutual funds. Instead, most commodities funds obtain exposure by buying commodity index futures, which don't perfectly reflect commodity prices at any given point in time.

Q: With those shortcomings in mind, do you still recommend any particular commodities funds?

A: If investors are OK with that imprecision, they could look to an exchange-traded note like iPath DJ-UBS Commodity Index (DJP) or to actively managed commodity futures funds such as Harbor Commodity Real Return (HACMX) or PIMCO Commodity Real Return (PCRAX). (Traded on major exchanges, exchange-traded notes are a type of debt security that combines the aspects of bonds and ETFs.)

Q: Why should investors see dividend-stock funds as an inflation hedge as opposed to, say, bonds?

A: Stocks should be part of most investors' inflationary toolkits because their long-run potential to beat inflation is much greater than is the case for bonds, and certainly cash. And dividend-paying companies offer an important advantage that fixed-rate investments like bonds don't: If business is good, they can actually increase their dividends. Those higher payouts, in turn, can help offset higher prices.

Among our favorite dividend-growth funds are Vanguard Dividend Growth (VDIGX), a traditional actively managed mutual fund, and Vanguard Dividend Appreciation (VIG for the ETF and VDAIX for the traditional index mutual fund).

Q: Who should be thinking the most about adding inflation-fighting investments?

A: Retirees. Only a portion of the income that most retirees earn, such as their Social Security income, will automatically step up with inflation. The income they draw from their portfolios, by contrast, will be worth less and less as inflation increases.