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Financial advisers take note: Smart money is already hedging against inflation

Real assets making up 10% of institutional 'inflation buckets'

Nov 14, 2014 @ 11:03 am

By Jeff Benjamin

Just because inflation is still a mere blip on the economic radar screen is no reason to ignore the potential threat to investment portfolios. That's the message institutional investors are delivering.

Maybe it's time for financial advisers to start following suit.

Quietly, but diligently, institutional-class investors representing multibillion-dollar pensions, endowments and foundations have been building “inflation buckets” loaded with various real assets that are designed to hold up against the negative effects of inflation.

The most popular reason institutions invest in real assets is still for the typical alternative-investment characteristics, including portfolio diversification. But increasingly, especially considering the Federal Reserve's monetary policy and tilt toward raising interest rates, institutional investors are embracing real assets as an inflation hedge.

(More: Worried about the end of easing? The effects of QE3 haven't even been felt yet)

A study of institutional investors released Nov. 10 by Greenwich Associates found that more than 80% of institutional investment consultants listed inflation protection as a primary reason for allocating to real assets, as do 65% of institutions that already invest in the asset class.

“The longer-term attraction of real assets is definitely the inflation sensitivity,” said Keith Black, managing director of curriculum and exams at the Chartered Alternative Investment Analyst Association.

“Another part of the attraction is that we're talking about something that is real and that people can actually touch,” he added. “After the financial crisis, people realized that the stocks and bonds they owned were just paper assets.”

Real assets, sometimes viewed as subcategory of the broader alternative-investment universe, include private real estate, listed real estate, timber, farmland, physical commodities, precious metals and master limited partnerships.

“From a diversification standpoint, real asset investments are quite different than what you're going to get in a traditional long-only stock or bond fund,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

“With the equity markets at record highs, it is unlikely we're going to see the same level of stock or bond market total returns that we've seen over the last three years,” he added. “The beauty of these is that they are not related, and you want to consider some places that haven't done as well to make sure you're properly diversified.”

While some categories of real assets are going to be difficult for advisers and retail-class individual investors to access, such as direct ownership of timberland, several mutual funds can provide exposure to areas likely to be beneficial during inflationary cycles.

Among real estate investment trusts, Mr. Rosenbluth highlighted Manning & Napier Real Estate Series (MNREX) and Stratton Real Estate (STMDX). For exposure to master limited partnerships, he listed, MainGate MLP Fund (AMLPX) and Tortoise MLP & Pipeline (TORTX) as good options. Two of his favorites offering exposure to precious metals include First Eagle Gold (SGGDX) and Gabelli Gold (GOLDX). And, under the general category of inflation protection, Mr. Rosenbluth cited Franklin Real Return (FRRAX) and Pimco Real Return (PRTNX).

According to the Greenwich Associates research, institutional investors are building up inflation buckets that represent about 10% their overall investment portfolios.

Keep in mind that real assets are not just pure hedges against the negative effects of inflation; they also represent basic portfolio diversification. And many of the real asset categories could be attractive additions to portfolios even without the immediate presence of inflation.

The category of real estate mutual funds, as tracked by Morningstar Inc., is up 23.8% so far this year. Global real estate funds are up an average of 11.2% over the same period. Equity limited partnership funds, representing master limited partnerships, are up an average of 12.4% from the start of the year.

Some of the liquid real asset categories are not going to look as attractive on a recent-performance basis.

Commodity precious metals funds are down an average of 4.8% this year, natural resource funds are down 6% this year, and inflation-protected bond funds are up just 3% this year.

Over the same period, the S&P 500 is up 12.3%.

“Ever since the financial crisis, real assets have grown into a trillion-dollar asset class,” Mr. Black said.

“I remember back in 2002, you could hardly find investments in this area,” he added. “But after 2008, people got spooked by paper assets because they realized they don't always know exactly what they own. But with real assets, people are thinking they like the cash flows and the fact that the investments are real and something you can actually touch.”

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