New Ways to Guard Against Rising Inflation

NEW YORK (TheStreet) -- Plenty of financial advisers are worried about inflation. High oil prices are hurting consumers, the advisers say, and heavy spending by the Federal Reserve could trigger inflation in coming years.

To protect against rising prices, the advisers suggest a traditional approach -- holding assets such as real estate investment trusts, gold and Treasury Inflation-Protected Securities. That strategy has often worked in the past, but the favored assets have all surged in recent years and now prices look rich.

Consider REITs. During the past three years, real estate funds returned 31.3% annually, ranking as the top-performing category tracked by Morningstar. As real estate shares climbed, yields fell. Now the average REIT yields 4.3%, near the record low of 3.8%, which occurred during the bull market of 2007.

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TIPS have also been top performers in recent years. Inflation-protected funds returned 9.1% annually during the past three years, outdoing the Barclays Capital Aggregate benchmark by 2 percentage points.

Now 20-year TIPS offer a puny real yield of 0.29%. The real yield on 10-year TIPS is negative, suggesting that the bonds will likely lag inflation.

Gold has surged in the past decade, climbing from $271 an ounce in 2011 to $1,653 now. If the price falls back to average levels, investors would suffer a big loss.

Should you stay away from the traditional inflation hedges? No, says Christopher Brightman, head of investment management for Research Affiliates, the money manager that oversees PIMCO All Asset ( PASAX).

Brightman says that investors should prepare for an era of more inflation by holding TIPS and commodities. But because the traditional assets are so expensive, investors should diversify their inflation portfolios more broadly than they have done in the past.

"If you just hold TIPS and commodities, you may have inflation protection, but you will not have much income," he says.

For additional income and inflation protection, he suggests holding floating-rate securities and high-yield bonds. Floating-rate funds currently yield 4.4%, while high-yield funds yield 6.7%.

Floating-rate securities tend to outdo conventional bonds by wide margins during periods of inflation. When inflation climbs, interest rates often rise.

That hurts conventional bonds, which can sink sharply when rates spike. But floating rate bonds are resilient, says Brightman. "The income from floating rate securities rises in lockstep with interest rates," he says.

Propped up by their fat yields, high-yield securities tend to be relatively resilient during times when most bonds are falling. Say the economy is growing and rates are rising. Prices of high-yield bonds may strengthen because investors figure that shaky companies are less likely to default.

To hold some of the inflation-fighting assets, consider PIMCO All Asset, which has returned 5.6% annually during the past five years, outdoing 84% of peers in the world allocation category. The portfolio invests in a shifting variety of PIMCO funds. Current holdings include PIMCO Floating Income ( PFIIX), PIMCO High Yield ( PHIYX) and PIMCO Real Estate ( PRRSX).

A new fund that seeks to combat inflation is Prudential Real Assets ( PUDAX). Prudential holds TIPS, commodities, gold and REITs. Portfolio manager Edward Campbell varies the mix as the sentiments of investors shift.

When investors are feeling confident and showing an appetite for risk, he emphasizes commodities and REITs, which tend to excel in bullish times. If the mood turns cautious, he holds more gold and TIPS, which are viewed as safe assets in difficult times.

When the sentiment is neutral, Campbell has 25% of assets in TIPS. The fund currently has 38.7% in TIPS. Campbell has 14.6% in gold and precious metals, an overweight position. "Investors are seeking to shun risk," he says.

Campbell argues that his fund is worth holding, even if inflation remains tame. The inflation-fighting assets can provide diversification because they sometimes do well when stocks languish. "During the past decade inflation was low, but gold and real estate did quite well," he says.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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