Tue, 5 Feb 2013

TIPS, real estate, and commodities are great inflation-hedging, liquid investments, says Morningstar’s David Blanchett, who details the importance of exposure to these assets.

Video Transcript

This video discusses Morningstar’s Real Asset Index, which is designed to help benchmark multiasset inflation investments; investors may also use the index to help shape the portion of the portfolio they have earmarked for explicit inflation protection. Note that the three asset classes discussed in the video—Treasury Inflation-Protected Securities, real estate, and commodities—are not intended to supplant traditional core asset classes like stocks, nominal bonds, and cash, but rather to augment them. The amount of inflation protection one needs varies by individual, with retired investors generally needing more inflation protection than younger people who are still earning paychecks.

Christine Benz: Hi, I’m Christine Benz for Morningstar.com. One of investors’ key challenges is to beat the rate of inflation over time. Joining me to share some tips on how to do that is David Blanchett. He is head of retirement research for Morningstar.

David, thank you so much for being here.

David Blanchett: Thank you for having me.

Benz: David, let’s talk about why and who needs inflation protection. It sounds like it kind of depends on where you are in your life stage. Let’s say, I am a person who is still working, and I am. How much do I need to build inflation protection explicitly into my portfolio?

Blanchett: Most people, as you noted who are still working, have an excellent inflation hedge; that’s their wages. Wages tend to increase through time by inflation. So, if you’re very young, most of your kind of total net worth is in your wages and so you don’t actually need an inflation hedge. But as you kind of move toward retirement and your human capital, your wages, is replaced with financial capital, your savings, you’d look more and more toward inflation-hedging investments to kind of make sure that as you move through time, the real value of your money stays on pace with inflation.

Benz: So, you have contributed to some research that constructed a Real Asset Index from Morningstar, and I’d like to talk about the constituent holdings within that index. What are the key asset classes that you think belong in an inflation fighter toolkit for a portfolio?

Blanchett: Well, there’s lots of different investments that you can use to hedge against inflation. There’s expected inflation and unexpected inflation. And the three main asset classes we looked at were Treasury Inflation-Protected Securities, real estate, and commodities. Those were kind of the three main aspects of the index because those three are not only kind of great hedges against inflation, but also very liquid investments for investors to purchase.

Benz: Let’s discuss then rough allocations to those three asset classes; how would you apportion…

Blanchett: Within the index, it’s 40% TIPS, 30% commodities that are long and short, 15% real estate, and then 15% long-only commodities—things like master limited partnerships and actual stocks that kind of go out and dig for iron and things like that.

Benz: So, let’s discuss the asset classes one by one because I think each of them have their own particular issues going on right now. TIPS, for one, have very low yields.

Blanchett: Yes, negative yields on some things.

Benz: Right. If you’re sort of looking at this research and thinking, Well, I don’t have much in TIPS, how should you approach that question given where TIPS are now?

Blanchett: So, TIPS have a negative yield, so if you buy them, you’re expecting to kind of lose money in a way because inflation appears to be quite low. TIPS are great hedge against unexpected inflation. As you know, that if inflation is high, if the CPI increases, then the yield and the principal value with TIPS increases, as well. So, while they are definitely low by historical standards, so are regular government bonds. I mean, it’s all kind of very low right now; TIPS has provided kind of that guarantee against inflation if it turned out to be really high.

Benz: Real estate, another category, has had a very good run, and now yields are quite low by historical norms. What would you say to investors who are thinking about adding that piece?

Blanchett: I think real estate would be a good alternative to bonds. I mean, real estate is risky as we’ve seen over the last few years. But still it does provide income, and it is a good hedge against inflation.

Benz: And then commodities, the futures-type commodities products, they’ve had their own issues; contango specifically. Let’s discuss what that is, and also why you would still recommend a futures-based strategy for commodities?

Blanchett: Contango is a negative roll yield. So, if I were to buy it today and hold it for three months, the three months from now it will be worth less than what I paid for it. So if nothing happens, I will lose money just holding that actual commodity, and there are different reasons for that. And so, within the index itself actually, we actually use a long-short strategy. It actually looks at where the roll yields are because historically, long-short commodities strategies have actually outperformed long-only strategies. Commodities in general, people need commodities, that’s why they are called commodities. You need to have things like trees and water and all these things. So, I think they will always be a good hedge against inflation because there is that inelastic demand for the things that commodities represent like fuel, things of that nature.

Benz: And yet the portfolio, the inflation-fighter index, does include long-only commodities. So, let’s talk about why that’s there as well as the commodities-futures exposure.

Blanchett: You can actually gain exposure to all commodities using futures. Also, we think that having some stocks that do have that kind of direct commodity hedge could work out well for investors. And we recognize there are different ways to kind of gain exposure to the commodity asset classes, and so we kind of looked at both routes as different parts of the index.

Benz: David, how should someone think about using this research? Should they model their inflation-fighter portfolio on this Real Asset Index? How would you say this index should be used?

Blanchett: So, I think there are kind of two different routes you can go. The first is it’s a good benchmark for the increasing array of active strategies. In the commodities space, it’s not like stocks and bonds. With the stock index, you can create an index based upon the size of the different companies. Well, with commodities and commodity of real asset investments, there’s kind of no one way to do things. We’ve looked at different active managers, different products, different things you can do, and we think this is a really good way to kind of gain exposure to these asset classes in a cost-effective way. The second is it can help you kind of figure out how should I invest my portfolio, what is a viable investment, and where do inflation investment vehicles help me achieve a goal?

Benz: Can you give me a rough benchmark? So, say, I’m a 60-40 investor, how much of my portfolio should be earmarked toward inflation-fighting investments like this?

Blanchett: So, actually in our managed accounts tool we have, that answer varies considerably because the question is, how much do you need in your portfolio to fight against inflation? If you’re very young, the answer could be zero. If you’re 70 years old and you’re sole goal is to create an income that is adjusted for inflation, it could be almost all of it. If you’re someone who is just looking to achieve this goal in retirement of income for life adjusted by inflation, then I would say that potentially most of your portfolio should be investments that are good hedges against inflation.

Benz: Well, David, thank you so much for being here.

Blanchett: Thanks for having me.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.