An inflation toolkit: fund tips to protect and profit

With high levels of inflation and interest rates on the rise, it is worth investors revisiting their portfolio. Here are some funds to consider.

In December, UK inflation climbed to the highest level since 1992, with forecasts estimating that it will continue to rise when January’s figures are revealed next week. It isn’t just the UK though, the US, the world’s largest economy, is seeing prices rise faster than they have since 1982. Europe, meanwhile, has its highest inflation since before the euro. Even Japan, the most deflationary of developed markets, is seeing marked jumps in consumer prices.

Prices are rising, but what does it really mean? Well for many it will mean a real wage cut and a significant cut in the real interest rate on savings, which brings us to discussing investment portfolios.

This year so far has been chastening for most equity investors and especially those investing in US technology stocks that had previously performed so well. Inflation is harmful for these companies because it also brings about rising interest rates.

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For these high growth companies, a lot of the expected revenue or cashflow of the company is many years into the future. To get the value of those cash flows today, we have to discount by a required rate of return (the minimum return investors require to hold an asset), which includes a risk-free interest rate, so when this increases those future cashflows, and therefore the company, is worth less today that it previously was.

Higher inflation also squeezes margins and makes borrowing more expensive as rates rise, again hurting high-growth companies, which often use debt to help finance growth.

Usually, when the outlook for equities is rocky investors would consider shifting to bonds. But, government bonds, normally seen as the most defensive assets, can also come under pressure. As interest rates rise, investors require a higher yield from bonds, causing bond prices to fall, which leads to losses for investors. 

So, what can you do?

Well for most investors it is probably most prudent to do nothing. If you are happy with how your portfolio is positioned for the long term, throwing it out and starting from scratch might not be the right course of action. Just be aware that some of the top performers we have seen - Fundsmith Equity and Scottish Mortgage (LSE:SMT) - may continue to see short-term blips, but they still remain excellent long-term holdings. But perhaps don’t expect the outperformance produced over the last five to 10 years in a period of rock-bottom interest rates.  

Predicting and timing inflation proves to be a fool’s errand for seasoned professionals, so as a retail investor making drastic overhauls is unlikely to serve you best unless you have upcoming liabilities you need to protect against.

However, it is always worth revisiting your portfolio and making sure it has balance and diversity across geographies and styles.

Here are some possible portfolio additions that have strong, long-term potential but might also help short-term stability if you feel you’ve got too much growth.

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UK Value

Jupiter UK Special Situations or Schroder Recovery. These deep-value funds are in many cases pricing in revenue declines rather than growth, so the impact of interest rates is lessened, as well as holdings in financial companies that can benefit from increased rates. The UK also houses materials and oil companies, which grow revenues as prices are pushed up.

Japan Value

My pick is Man GLG Japan CoreAlpha. Much maligned for some tough times recently, the fund has performed strongly over the last year. The fund is deep value and has significant exposure to banks, whose profits are linked to interest rates.

Index-Linked/Real Asset Income

A number of trusts or funds give exposure to assets that often come with RPI-linked cash flows, which creates inflation-proof income over time. The most obvious of these would be something like Supermarket Income REIT (LSE:SUPR) where rents have RPI uplift, but infrastructure funds such as FTF ClearBridge Global Infrastructure Income or VT RM Alternative Income offer more diversified exposure to real assets, which benefit in inflationary environments.

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Commodities

WisdomTree Enhanced Commodity ETF or JPM Natural Resources offer direct correlation to commodity prices. Given that we are in a cost push inflationary environment having direct exposure to those increasing prices is a good way to protect your portfolio against it.

Many investors look to gold to protect against inflation, although its track record is mixed. The iShares Physical Gold ETC (LSE:IGLN) provides exposure.

Wealth preservation investment trusts

Finally, if inflation is a huge worry, there are managers out there who have been inflation bears for a good while and who see any loss of capital as a slight on their process. Entrusting a chunk of your portfolio to LF Ruffer Total Return or to Capital Gearing (LSE:CGT) is a good way to sleep at night. While returns won’t be bumper, these managers have built portfolios to weather the investing storms such as those we see now.

Scott Thompson is a senior analyst for manager selection services at Morningstar.