You have to hand it to Bill Gross for putting his money where his mustache is.
Recently the managing director of Pacific Investment Management, or Pimco, said he trimmed his position in Pimco's signature Total Return bond fund and placed the proceeds in a series of inflation-averse funds such as Pimco's Commodity Real Return Strategy fund.
The money manager's statement shouldn't have been a surprise to Pimco investors who saw his December investment outlook. In that report, Gross ranked his five favorite asset categories in what he calls "this current reflationary reversal." Gross likes, in order: commodities, foreign currencies, real estate, Treasury inflation-protected securities and non-dollar-denominated foreign bonds.
Unfortunately for the average investor, Gross's top five isn't exactly flavored with the most vanilla of financial products. Even financial professionals might find these asset classes tricky to comprehend. And finding arcane investment instruments like non-dollar-denominated bonds might not be the average retail broker's strong suit.
So for those mutual fund investors looking for a simple yet effective strategy to follow Gross on his anti-inflation scavenger hunt, here are a few funds to consider:
1. Commodity Price Funds
Gross didn't have many choices when he started shifting his money toward commodity price funds six months ago. There are only two funds that offer direct exposure to commodity prices: Pimco's
Commodity Real Return Strategy fund and Oppenheimer's
Real Asset fund, according to Morningstar's Langdon Healy.
Healy says that Gross' choice of Pimco's commodity fund was clearly a logical one for a Pimco managing director, but also that it's the better of the two funds. "We prefer the Pimco fund primarily because we think its benchmark, the Dow Jones-AIG Commodity Index, offers better commodity diversification than the Goldman Sachs Commodity Index, the benchmark for the Oppenheimer fund," says Healy. "The Goldman index is structured so that petroleum can completely overwhelm other commodities, but the Dow Jones Index caps energy exposure at one-third of assets."
Another relevant reason Healy chooses Pimco's fund over Oppenheimer's: Pimco knows how to beat the indices using bonds and derivatives. This is an especially important point because this is not your average natural resources equity fund. Instead of buying stock in energy providers such as
, the fund's managers use leveraged financial instruments such as futures contracts to provide exposure to oil prices. Therefore, at times when commodity prices are outpacing returns for commodity producing stocks, the fund will outperform equity funds that invest in natural resource company stocks.
Pimco has effectively been using Treasury inflation-protected securities, or TIPS, as collateral for its derivative-based exposure. (TIPS, which have been soaring as of late, are also included in Gross' favorite inflation-fighting asset classes.)
To be sure, Healy warns investors only to consider the Pimco fund as "an alternative asset class for a long-term commitment" due to its volatility and lack of correlation with equity markets. With a hefty front-end load of 5.5% and an expense ratio of 1.24%, it's not cost-effective to jump in and out of the fund anyway.
Investors who prefer exchange-traded funds to mutual funds might also investigate the iShares Dow Jones
US Basic Materials fund,
iShares Goldman Sachs Natural Resources fund, or the
Select Sector SPDR Materials fund.
2. Foreign Currencies
Gross favors nondollar-denominated global bonds to their U.S. counterparts in a rising inflation environment. Gross says in his December report that "U.S. bonds, aside from TIPS, currently offer less in the way of real interest rates than global bonds."
Aside from yield, one of the advantages Gross sees in non-dollar-denominated global bonds is the added currency kick from the dollar's demise. Or, in Nietzscheian terms: What doesn't kill the dollar makes foreign currencies stronger.
One fund that concentrates on strengthening foreign currencies is the
Franklin Templeton Hard Currency Fund. The Franklin Templeton Hard Currency Fund invests primarily in high quality, short-term money market instruments (and forward currency contracts) denominated in currencies of foreign countries and markets that historically have experienced low inflation rates.
The fund is currently yielding 7.35%, but cost-conscious investors might beware of the 2.25% front-end load on top of the 1.50% expense ratio. After all, despite its global focus, the Franklin Templeton Hard Currency Fund is still a bond fund, and higher fees hurt bond fund returns more than equity funds.
3. Real Estate
"Like politics, most home prices are local so you should know more than I do," writes Gross in his December note to investors. Gross' wisdom is appreciated, but not especially practical for those trying to pick a real estate fund to hedge against impending inflation.
Morningstar's REIT analyst Dan McNeela, however, was generous in providing some real estate fund offerings, most notably his No. 1 choice, the
3rd Avenue Real Estate Value Fund.
"3rd Avenue Real Estate Value Fund has compiled an attractive record and has gone off the beaten path to discover real estate companies that find land and develop it," says McNeela. "The fund is unlike traditional REIT funds which focus on REITs that collect rents from office buildings."
3rd Avenue Portfolio Manager Michael Winer says his fund's goal is long-term capital appreciation through real estate, as opposed to investing in REITs simply to collect the yield. The 3rd Avenue fund yields only 2.11% compared with 3.2% for Morningstar's real estate category. "We look for companies that have owned land for a long time at a low-cost basis. These companies can develop agricultural, ranch and forest land into higher and better uses," says Winer. "The key is having a terrific balance sheet so they can reposition land without incurring huge debt."
For a traditional yet aggressive real estate fund, McNeela suggests the
Security Capital US Real Estate Fund. It has an above-average yield of 4.11%, but investors who are averse to concentrated funds might want to steer clear of it, since it holds fewer than 30 stocks in concentrated proportions.
4. Treasury Inflation-Protected Securities
Gross didn't have to travel very far when he was looking for a solid TIPS fund. He just put his money into Pimco's
Real Return fund.
"In terms of pure skill and ability to outperform, Pimco Real Return fund takes the cake," says Morningstar TIP fund analyst Eric Jacobson. According to Jacobson, Pimco gooses returns in its Real Return fund through an enhanced strategy called "Bonds Plus" whereby it borrows money at the London interbank offered rate, or Libor, and invests it in a short-term duration bond portfolio. Jacobson says the Pimco fund also receives an additional kick because the portfolio manager doesn't confine himself to U.S. Treasury TIPS. Corporate bonds are often thrown into the mix as well.
Despite the fund's savvy financial strategies for outperformance, portfolio manager John Brynjolfsson views lowering risk in his fund as being equally important as adding return. "We see risk as the flip side of the coin to adding value. Our job is to find those sources where we can add the most value with the least added risk," says Brynjolfsson. "Pimco's experience and resources put us in a good position to deliver on that goal."
Investors looking to follow Gross's lead but favor plain-vanilla TIPS funds might try Vanguard's
Inflation Protected Securities fund or Fidelity's
Inflation Protected Bond fund.
One note of caution on TIPS despite Gross's allegiance to the asset class: When inflation is dormant and interest rates spike (as they did last summer), TIPS can see larger losses due to the long maturity and small coupon.
5. Global bonds and Equities Denominated in Nondollar Currencies
There are a number of funds with strong track records in this category. Lynn Russell of Morningstar suggests that investors take a look at the
Blackrock International Fund and the T. Rowe Price
International Bond Fund.
Both funds stick to bonds issued by developed countries, although T. Rowe's fund tends to lean heavier on Japanese debt than euro-land nations. Neither fund sports a load and both maintain similar expense ratios around 0.9%.
Russell says the key to the success of these two funds is their ability to handle the volatility inherent in currency exposure. And with the dollar's decline, unhedged global bond funds have been winners over the past year. However, Russell is quick to remind investors that "it can move in the other direction as well."
"When it comes to global bonds, the three most important things are country, currency and interest rate risk," says Russell. "This is not as straightforward as blue-chip stocks."