About a year ago I wrote an article in this space entitled "Retirement Risks Are Mounting". This conclusion was based on the triple threat to retirees - and those close to retirement - of low bond yields, lofty stock market valuations, and rising inflation.
Since we haven't experienced the current level of consumer inflation in this country for about 40 years, this economic environment is uncharted territory for many investors. That being the case, the financial press has been busy churning out articles on what investors should do to protect their portfolios from inflation and rising interest rates. Along these lines, Ginger Szala, managing editor of ThinkAdvisor.com, recently asked Financial Planning Association members how they were positioning client portfolios to protect them from inflation. My response, which appeared in the resulting article "How to Protect Portfolios When Inflation Hits: Advisors' Advice", was the following:
"I've always had a small, i.e. 5-10%, allocation to commodities in most client portfolios as an inflation hedge. If you believe that the bond side, in particular, of a portfolio is exposed to higher interest rates through rising expectations for inflation, or through the Fed's response to them, then it makes sense to have something in the portfolio that has correlated very strongly with inflation in the past, i.e. commodities.
On the bond side of the equation, I've been tilting portfolios to exposure that is shorter in duration, i.e. less sensitive to moves in interest rates, and lower in credit quality. And on the equity side of the portfolio, I've been tilting portfolios to value and away from growth."
If you read what other financial advisors recommended as inflation protection in this article, you'll notice that several of them mentioned TIPS, i.e. Treasury Inflation-Protected Securities, and that I didn't recommend them. I have nothing against TIPS. In fact, way back in 2004 I gave a presentation on TIPS to our local NAPFA (National Association of Personal Financial Advisors) study group. And Five Seasons has used TIPS mutual funds in client portfolios in the past (and probably will do so again in the future when they are more attractively priced).
However, despite their name, Treasury Inflation-Protected Securities are not a particularly effective inflation hedge. And perhaps more importantly from a portfolio management standpoint, their returns have a fairly high correlation to those of nominal, i.e. non-inflation-protected, bonds.
The reason for this is that TIPS are essentially a pure bet on real (i.e. post-inflation) interest rates, while real interest rates are also a component of the yield on nominal bonds. When inflation rears its ugly head, the Federal Reserve almost inevitably tightens monetary policy, which drives up real interest rates. So prices of both TIPS and nominal bonds suffer in tandem, and investors (and I presume advisors using TIPS as an inflation hedge) are left to wonder what went wrong.
But let's stop talking hypothetically, and look at the returns on commodities and TIPS during our current bout with inflation. The Consumer Price Index first rose at a 5% annual rate in May 2021 and has been rising almost uninterruptedly since then to its current 8.5% rate of inflation. During the past year, commodities as measured by the Bloomberg Commodity Index have risen 24%, while TIPS as measured by the performance of the TIPS iShare ETF have returned about negative 6.5%.
The proof is in the pudding. When you want an inflation hedge and an asset class uncorrelated to bonds, and to some extent to stocks, commodities fit the bill. The moral of the story? Not all inflation hedges are created equal. And apparently, not all investment advice is created equal either.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.