The funds and sectors keeping ahead of inflation, and those falling short

Maintaining the “real” value of your wealth is one of the main reasons for investing, but periods of high inflation can make this a very difficult task.

Over the last three years, the UK Consumer Price Index (CPI), which is the most widely used measure of the price of goods in the UK, has risen a cumulative 21%, with the annualised figure topping out at 11.1% in October 2022. The inflation rate began ticking up at the beginning of 2021.

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While inflation is now slowing, with CPI falling to 4.6% in October 2023, the last three years has been incredibly damaging to the real wealth of many investors.

But some investment sectors have managed to deliver impressive inflation-adjusted returns, while other sectors that you might have expected to protect against inflation have disappointed.

Inflation-beating funds and sectors

Data from FE Analytics shows that just six of the Investment Association’s 57 fund sectors delivered returns above 21% from 17 November 2020 to 17 November 2023.

They were India (52% gain on average), Commodity/Natural Resources (46% gain), Latin America (30%), North America (29%), Global Equity Income (25%) and UK Equity Income (23%).

Equity income strategies would have been expected to perform well during periods of high inflation as adding dividends to total returns gives investors a regular return. Dividends in high-quality companies can also rise with inflation, as companies can increase prices and therefore profits.

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The other big theme were funds exposed to natural resources. Mining and oil companies have had a fantastic past three years, as higher commodity prices (which were one of the main causes of high inflation), led to bumper profit and dividends for the sector. Commodity stocks are prevalent in UK Equity Income funds, as well as among Latin American companies.

The strong performance for Indian shares is linked to its economy and politics, with investors moving money out of China, which is deemed too risky politically, and into India, where a democracy of more than one billion people is welcoming foreign investment. It also has a very young population compared with China’s ageing population.

Breakthroughs in artificial intelligence have boosted North America funds, with the “Magnificent Seven” of Apple, Microsoft, Nvidia, Meta, Alphabet, Amazon and Tesla driving markets higher.

Some of the top funds over three years include: Jupiter India up (97% gain), Liontrust India (73% gain), iShares - Oil & Gas Exploration & Production UCITS ETF (241% gain), BlackRock - BGF World Energy (205% gain) and WS Guinness Global Energy (198% gain).

The top North America funds over three years include BNY Mellon US Equity Income (73%) and FTF - ClearBridge US Value (64%), and the top UK Equity Income funds over three years include Schroder Income (71% return) and TM Redwheel UK Equity Income (64% return).

But ‘real’ returns have largely been negative

Unless you invested in those six sectors, the likelihood is that your returns have been negative over the past three years when adjusted for sky-high inflation.

A number of themes emerge among the losing sectors.

First, bonds have been hammered as a result of rising interest rates and high inflation. Bond prices generally fall as interest rates rise, as newly issued debt will come with a higher yield than existing debt. Inflation also corrodes the relative value of the fixed income on offer.

Bond losers include Sterling Corporate Bond (in which the average fund is down 12%), Global Corporate Bond (down 9%) and UK Gilts (down 26%).

But the biggest bond sector loser has been UK Index Linked Gilts, where funds fell 32% on average. While inflation-linked bonds adjust their coupon and principle for the RPI inflation rate, they tend to have very high “duration”, which is a measure of sensitivity to interest rates, as they have a long period before they mature.

With bond yields now higher (a result of lower prices), investors can now expect to receive an inflation-beating return from the sector, as debt yields are above inflation rates, called “positive real yields”. Professional fund managers recently concluded that bonds would be the best-performing asset class in 2024.

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Investors in China have also suffered a lot over the past year, with the typical fund falling 35%. China’s extended lockdowns and slow recovery from the pandemic, as well as geopolitical tensions with Taiwan and the United States, have hurt sentiment.

Smaller companies, which tend to be affected by economic problems and come with higher valuations, also struggled as inflation rose.

The UK Smaller Companies sector fell nearly 5%, while European Smaller Companies rose just 2% and North American Smaller Companies rose just 7%.

Real assets, such as property and infrastructure, also failed to beat inflation. UK Direct Property rose 3.5%, while Infrastructure rose 7%. Property and infrastructure cash flows tend to rise with inflation, but valuations of assets fell as investors moved money into the bond market, where income is now higher due to interest rate rises.

Losing funds included AXA Sterling Index Linked Bond (down 43%), Fidelity Index Linked Bond (down 44%), Baillie Gifford Investment Grade Long Bond (down 34%), Schroder Long Dated Corporate Bond (down 38%), Jupiter UK Smaller Companies Focus (down 32%), Octopus UK Micro Cap Growth (down 23.5%), GAM Star China Equity (down 47%) and Templeton China (down 47%).