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How to protect against inflation's burn

Norman Raschkowan admits a personal bias toward gold as an inflation hedge, but having grandparents who lived through the 1920s hyperinflation in Germany will do that to you.

"I was raised to have a positive view of gold as a inflation protection or a sort of insurance policy," said Mr. Raschkowan, chief investment officer for the mutual fund company Mackenzie Financial Corp.

Inflation has been tame through the past two years of financial crisis and recession, but recent surges in the price of oil and other commodities have fed concerns about a resurgence. Mr. Raschkowan urges investors to make sure inflation is among the risks they have prepared for in building their portfolios, and he highlights gold, commodities and real return bonds as the best tools for the job.

At least some degree of inflation is a near constant in the economy. The concern is that price increases will leap ahead of the low, steady rate preferred by the Bank of Canada to ensure a smooth-operating economy. The inflation rate watched by the central bank has so far shown no sign of a resurgence and, in fact, there are some financial people who question whether inflation is a risk at all right now for the broad economy.

"Yes, we see gas prices going up and food prices going up like crazy, but it's hard to find other places where it's happening," said Robert Sneddon, president and portfolio manager at CastleMoore Inc.

German hyperinflation in the 1920s is the most dramatic example of runaway price increases - think of those images of people pushing wheelbarrows of largely worthless paper money. Here in Canada, inflation was last a major issue in the early 1980s, when it reached 12 per cent.

In recent years, inflation has loomed as a risk and then receded. "There's concern that soaring prices for oil and food are going to push the cost of living higher than we've seen it in years," I wrote back in May, 2008 (read that Portfolio Strategy column online: As you may remember, it was only a few months later that an apparent collapse of the global financial system obliterated the inflation threat.

Inflation may not be an immediate concern today, but it can't stay dormant forever. When it returns, gold will undoubtedly get a lot of attention because of its proven record of doing what any good inflation-fighting investment should do, which is rising in price as the cost of living moves higher.

Gold is also a safe haven investment, which explains why the price has soared over the past couple of years to about $1,400 (U.S.) an ounce. Mr. Raschkowan doesn't buy into the expectation of some gold bulls that the price will rise to $2,000 an ounce this year, but he does see some benefit in holding gold stocks.

"I think gold companies are going to be seeing very strong earnings and raising their dividends," he said. "And in a portfolio context, gold stocks tend to move out of sync with the rest of the market. They tend to reduce overall volatility."

Not everyone buys the gold-against-inflation argument, however. Sheryl Purdy, vice-president of Leede Financial in Calgary, said the time to buy gold was several years ago. Today, she sees too much downside risk. "From today's point of view, as to whether I'd recommend a client get into gold, the answer is no."

Ms. Purdy prefers oil as an inflation hedge, a view shared by the authors of the respected Boeckh Investment Letter. They argue that since inflationary fears are coming directly from commodities, exposure to oil and other commodities offers better inflation protection than gold.

A mix of small, medium and large North American energy companies are what Ms. Purdy has been emphasizing in client portfolios. "The way I've positioned it with clients is that if they're looking for any sort of a hedge against potential inflation, it's oil," Ms. Purdy said.

Suncor Energy is an example of a large company she's been buying on behalf of clients, while Spartan Exploration and Surge Energy are medium and small stocks she's been recommending. She's particularly bullish on small-size oil stocks - junior oils - with a potential to grow into the sort of mid-size company that has largely disappeared in recent years owing to consolidation in the oil patch.

Mackenzie's Mr. Raschkowan believes broad commodity exposure is an effective inflation hedge. Good news here - you probably already have this if you hold a mutual fund or exchange-traded fund that reflects the entire Canadian stock market. As of late this week, energy and materials stocks (largely mining) accounted for almost 51 per cent of the S&P/TSX composite index.

Rising inflation would be cause for caution when considering the shares of companies that do not have a free hand to raise prices quickly to keep up with inflation, Mr. Raschkowan added. Examples would be companies in the consumer staples sector, notably food retailers.

Mr. Raschkowan said that the more your portfolio is weighted to bonds, the more urgency you should feel about preparing for the inflation risk. In an inflationary world, bonds are defenceless and could fall hard in price, especially government bonds (relax, they still pay interest and return your money on maturity).

Real-return bonds offer semi-annual interest payments that rise with inflation, and the amount you get on maturity is inflation-adjusted as well. Still, they're not the no-brainer investment they might appear to be for those worried about inflation.

The issue is that real return bonds have risen a lot in price lately. The DEX Real Return Bond Index is up enough in the past year to have squeezed the yield down to about 1.2 per cent (prices and yields move in opposite directions). By far the easiest way for investors to buy real return bonds is through exchange-traded funds or mutual funds, both of which charge fees that erode this already thin yield.

Even so, Mr. Raschkowan believes the inflation protection offered by real return bonds makes them a portfolio staple right now. The same goes for corporate bonds, which he prefers over government bonds right now because they hold up somewhat better in an inflationary world.

"I would probably have a combination of real return bonds and high-grade corporate bonds, and I would limit the term of the corporate bonds to no more than five years on average."



The amount of interest paid by real return bonds is adjusted for inflation, and so is the amount you get at maturity. For that reason, these bonds are widely considered to be an essential inflation-fighter. Here's a survey of mutual funds and exchange-traded funds that hold real return bonds,

which are also known as inflation-linked bonds.

FundTickerFee(%)1-Yr. Return(%)
BMO Real Return Bond Index ETFZRR-TSX0.25 n/a
iShares Dex Real Return Bond Index FundXRB-TSX0.355.3
Mutual Funds
FundAssets ($ Mil.)Fee (%)1-Yr. Return (%)
TD Real Return Bond1,5061.423.9
Investors Real Return Bond2911.963.5
AGF Inflation Plus Bond2801.770.8
Mackenzie Sentinel Real Return Bond2661.573.5
Renaissance Real Return Bond1781.63.8
Dynamic Real Return Bond681.832.2
PH&N Inflation-Linked Bond170.535.5
PIMCO Canadian Real Return Bond n/a n/a n/a


Primers on real return bonds are available here:

Bylo Selhi's Smart Mutual Fund Investing

for Independent Canadian Investors

The Million Dollar Journey blog


Rob Carrick

© 2007 The Globe and Mail. All rights reserved.

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