Choose Gold Funds Over TIPS as Inflation-Busters

Treasury Inflation-Protected Securities are better than gold?

Not a chance.

Last week, TheStreet.com published an article making the case for TIPS. It quoted Ken Volpert, a portfolio manager at Vanguard, as saying that TIPS beat gold when it comes to saving assets from the ravages of consumer price inflation.

In other words, pick the bullion exchange-traded funds streetTracks Gold Shares ( GLD) and iShares Comex Gold Trust ( IAU) over iShares Lehman TIPS Bond ( TIP).

TIPS indeed could be a strong contender in the battle for inflation-busting supremacy.

But there's a problem: TIPS have barely been stress-tested, so only time will tell.

"If you really are worried about inflation you don't want to try an untried asset class," says Don Coxe, global portfolio strategist at BMO Financial Group in Chicago.

TIPS are government bonds which pay a variable coupon based on changes to the consumer price index, and were launched only 10 years ago. Although the interest rate is fixed, the principal is adjusted higher in line with changes to the consumer price index.

Volpert makes a strong argument in favor of TIPS, saying that "as inflation increases over time, your real income -- which is paid to you -- is increasing by the rate of inflation." He further argues that "you get the principal back plus the actual inflation that eroded the real value of the money as well."

They seemed to have worked well during the most recent period, but that has been relatively tranquil compared with 30 years ago when inflation last got really out of hand in the U.S.

"TIPS were not around at a time when you had a wild bond market like the 1970s," Coxe says.

During that period yields went to 17% from 7%, he explains. And because the value of a bond moves inversely with market yields, investors who were holding fixed-income securities during that period took it on the chin.

To watch Simon Constable's video take of this column, click here .

It's something Vanguard's Volpert knows only too well. He argues that changes in interest rates have eight times more impact than an equivalent rise in inflation expectations. Or more simply, a 1% jump in the real rate of interest would reduce the market value of the bond by 8%. That contrasts with a 1% increase in the CPI, which would result in only a 1% rise in the TIPS principal.

And that's the theoretical best outcome.

The truth, says Coxe, is "we really don't know" how TIPS would behave if inflation jumps and the credit market is thrown into even more turmoil.

One of the big problems with the inflation adjustment is how inflation is measured.

"The CPI is not rigged, but it is flawed," says Peter Bernstein, a 50-year veteran of financial markets and author of multiple finance classics including The Power of Gold: The History of an Obsession.

The issue is the inclusion of prices for durable goods, such as washing machines and refrigerators, in the calculation of the index.

But those items have been declining in price as China has become a lower-cost manufacturer of the items, holding the index down.

"It's understating the prices that people confront every day," adds Bernstein.

This means people are feeling the effects of buying higher cost food and energy each day, but they rarely get a new air conditioner or washing machine. So inflation, on a day-to-day basis, is hitting consumers at a rate higher than the CPI.

While the discrepancy related to durable goods might be insignificant at relatively low levels of inflation (below 2% to 3%) or over short periods (two to three years), those discrepancies do start to add up if there are double-digit price gains over multiple years.

So when you most need inflation protection, the index measure might work against you.

Gold's historic performance was spectacular when it last mattered most. Prices rose from $35 an ounce in 1971, when the U.S. took the world off the gold standard to a high of over $800 in 1980 through a decadelong period of rising inflation.

And more recently gold has done well again.

Over the past five years the price of an ounce of the metal has more than doubled, up 126%, while an investment in the five-star rated ( PRRIX) PIMCO Real Return would have garnered the holder little more than 30%. The ( VIPSX) Vanguard Inflation-Protected Securities fund would have done slightly worse than that, according to data from Morningstar.

"If something goes wrong with the economy you want the biggest bang for your buck," says author Bernstein.

"And if it doesn't go wrong gold will be a poor investment, but everything else like stocks and bonds will do well."

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