April 30, 2012: Inflation Hedges For All Weather Portfolio Building

05/01/2012 Share 0 comments

Re-balance Cycle Reminder

Based on our monthly re-balance calendar, the next re-balance time will be on Monday, May 28, 2012. You can also find the re-balance calendar of 2012 on 'My Portfolios' page.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Inflation Hedges

In the previous newsletter, we introduced the concept of all weather portfolio building based on the four corner foundation (first introduced by Harry Browne for his permanent portfolio). In this article, we will go into some more details in covering the inflation corner.

Inflation is perhaps the biggest threat for retirees or anyone who would like to preserve wealth or purchasing power on the inflation adjusted basis. In a normal economic process, inflation occurs and purchasing power decreases in nominal terms (i.e. using the same amount of money). Inflation can increase in a gradual manner (such as annual 3-4% CPI (Consumer Price Index) increase) or in a sudden or violent manner (in 1981, CPI rose about 10.3%). Anemic inflation is not harmful to economic development but violent inflation can derail economy and cause recession.

The following are several types of inflation hedges (anti-inflation):

Precious metals

The representatives of precious metals are gold and silver. Gold is perhaps the most well known and the oldest metal that is considered to be the hard currency to store value. Throughout history, human's fascination with gold has been well documented. A good read on this subject would be the book The Power of Gold written by Peter Bernstein.

Gold, however, has several drawbacks to be used as a hard currency. These include gold's limited industrial usage. This topic itself deserves a much longer discussion and it is beyond the scope of this article.

Investing in gold can be through physical gold bullions, ETFs (such as GLD and IAU) or futures.

Silver has dual properties: it is a precious metal while in the mean time, it has many industrial usages.

Gold is traditionally perceived as the last resort for store of value. However, we have to emphasize perceived as there is no absolute reason why gold is the store of value. Throughout the history, gold has always been the sought after directly linked asset in an inflation or currency crisis. But there is no absolute guarantee that this will happen again in the future.

Commodities

Commodities such as oil, food and industrial metals are directly linked to everyday's prices, thus, they are more or less direct inflation hedges. However, during a financial crisis, commodities other than precious metals are weak as disruption in economy usually causes weaker demand (at least temporarily). They are thus less effective for financial crisis hedging.

Inflation protected bonds

Treasury Inflation protected securities (TIPs) were first introduced by the U.S. government in 1997, though such securities had been introduced much earlier in Europe. In addition to TIPs, companies such as JP Morgan & Chase also offered inflation linked bonds. Fidelity Inflation Protected Bond Fund (FINPX) has some small exposure in corporate inflation linked bonds historically.

One of the main issues for TIPs is that since they were introduced in 1997, they have been bided up steadily. They are now offering negative real yields (the nominal yield minus current implied inflation rate)!

There are many reasons behind current TIPS' negative yields. For example, PIMCO recently argued that TIPS' negative yields are not a major concern as that reflects all dollar-denominated asset classes are discounted with very low real yield.

ETFs that invest in TIPS include iShares TIP and PIMCO's 15+ Year US TIPs ETF LTPZ. LTPZ can be a good match with long term Treasury bonds (such as iShares 20+ Treasury bonds TLT) because its long maturity/duration offers adequate hedge with TLT (a duration match for hedging purpose is another interesting topic we will address in the future articles).

Floating rate bonds

Floating rate bonds offer dynamic yield adjustment based on current interest rates. They are good investments for current inflation hedge but are not good for expected inflation hedge. Often, expected inflation drives down asset prices such as bonds ahead of actual inflation. A longer term TIPS, for example, offers better expected inflation hedge.

However, floating rate bonds are safer investments for an environment like today as rates are already extraordinary low.

REITs

Among equities, Real Estate Investment Trusts (REITs) are perhaps one of the best inflation hedges. Based on a report by well known REITs investment management firm Cohen & Steer, REITs' dividend and Net Operating Incoming (NOI) are all positively correlated with inflation. The following chart shows the dividend growth:

From the report, it also showed that Net Operating Incoming (NOI) has 0.45 correlation with CPI. This is a strong correlation.

However, REITs are often treated as stocks during a crisis. Again, these real estate companies might experience tight financial lending condition that can affect their operations in a period of high expected inflation. Simply put, REITs are good long term inflation hedge but they are not as direct as gold or TIPS.

Putting things together

There are several ways to cover the inflation corner. One is to simply invest in several subclasses mentioned above. For example, you can simply allocate to TIPS, as what was mentioned in Permanent Income Portfolio in the previous newsletter. Or you can allocate to both gold and TIPS in equal amounts or with different percentages. 

An active way is to adopt a 'tactical' selection approach to choose among the above securities for this corner's portfolio. Expert users can customize a portfolio such as P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs by changing the fund input list (remember this portfolios uses a strategy that is essentially a momentum strategy).

The third choice is to use some of excellent real return mutual funds such as PIMCO's real return fund. We will have a more detailed analysis on this topic later.

Portfolio Reviews

It is time for us to review how our basic six core asset ETF benchmark plan's TAA has performed compared with several well known tactical asset allocation funds mentioned in Year End Tactical Asset Allocation Fund Review: Part II

• Cambria Global Tactical ETF (GTAA): manager Mebane Faber advocated using trend and timing over major and minor diverse assets.
• Goldman Sachs Dynamic Allocation (GDAFX): It seeks to achieve its investment objective by investing primarily in ETFs, futures, swaps, structured notes and other derivatives that provide exposure to a broad spectrum of asset classes, including but not limited to equities (both in US and non-US companies), fixed income (US and non-US, investment grade and high yield) and commodities. The fund may also use leverage (e.g. by borrowing or through derivatives). At best, this fund uses both asset trend and fundamentals to decide asset allocation dynamically.
• Arrow DWA Tactical (DWTFX): the fund is managed by the famed Dorsey Wright & Associates using well known relative strength methodology, similar to MyPlanIQ’s Tactical Asset Allocation(TAA)

Portfolio Performance Comparison (as of 4/30/2012)

More detailed year by year comparison>>

Market Overview

Economic data released today (4/30/2012) are not encouraging:  Dallas Fed Manufacturing Index plunges to negative reading (from 10.8 to -3.4), Chicago PMI is now lowest since November 2009 (from 62.2 to 56.2). Other news from Europe continued to be negative also.

Again, three major risk assets (commodities, international equities and emerging market equities) are all ranked at the bottom.

See MyPlanIQ 360 Degree Market View for more details.

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