Can mutual fund be an inflation hedge?

Globalization helps developed economies to benefit from the low production costs in emerging markets during the booming past decade.....

YT Kum, CFA 02.07.2008
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Globalization helps developed economies to benefit from the low production costs in emerging markets during the booming past decade. However,this advantage has produced a mirage - inflation is well contained globally even though the monetary policies have been relaxing around the globe for years. Now,when global economic growth slows and production costs in emerging markets peak,inflation is back to eat into everyone's purchasing power and all pinched investors are finding a way out. In this regard,can mutual fund help?

Under the inflation scene,"inflation hedge" is the phrase on everyone's lips,but what does it mean precisely? Inflation hedge refers to investment designed primarily to protect against inflati

on risk. Inflation-linked securities,for instance,are regarded as good hedge to inflation,because principals of these securities,like Treasury Inflation Protected Securities (TIPS),are directly adjusted to Consumer Price Index (CPI),a broadly used inflation measure,periodically. Although inflation has become a global worry,Inflation-linked bond funds are not popular in Hong Kong. It is partly because they mainly hedge against inflation in U.S. or Europe,but not in Hong Kong. Besides,with around 0.8 percent management fee on average,the cost of holding these funds cool investors' interest.

There are only nine mutual funds with inflation hedge feature available to Hong Kong investors and these offerings are not exactly designed for Hongkongers,as they generally aim at hedging against"global inflation". Although inflation hedge mainly aims at capital protection,long-term performances of these inflation linked funds are quite attractive actually. As of May-end this year,average funds in Morningstar Euro Inflation Linked Bond category gain 9.06 percent annually in the past three years,which is 4.14 percent higher than that of Morningstar Euro Global Bond category. Despite these savvy gains,bond funds may be too conservative for some aggressive investors,thus some investors are looking for funds with much higher yields.

Conventional investment wisdom says some hot commodities,such as crude oil and gold,can be a hedge against falling greenback and rising inflation. Thus some investors expect that energy funds and precious metal funds can fare well amid inflation. Is it really the case? The answer is yes and no. Yes,prices of these commodities may be influenced by inflation and inflation expectation,but they are not the only factors that matter. Crude oil price,for example,could be affected in the future by strong dollar and easing consumption. Therefore,there is no guarantee that these alternatives can post satisfactory gains amid rising inflation. Investors have to consider some other factors as well.

As general investors are growing concerned about the global inflation problem,it is expected that the phrase"hedging against inflation" will be commonly used as some mutual funds' gift-wrapping paper. But it would be investors' duty to investigate their real hedging power. For example,some investors and fund houses believe that Asian bond funds can serve as an inflation hedge,because some Asian countries,like China and Singapore,may accelerate their currency appreciation to weather inflationary pressure,and hence Asian bond funds are the beneficiaries. Nonetheless,not all Asian countries would take this move to tamp soaring prices,and,even they do,the pace would vary widely among countries. In this case,investors should analyze mutual funds portfolio by portfolio to see whether these funds are real beneficiaries. Not only Asian bond funds,some other funds like real estate equity funds may claim themselves inflation-proof,but investors should always think more than they are told before purchasing.

In sum,if investors want to protect their eroded purchasing power,inflation linked bond funds are the best choice,though they are not perfect. Besides,investors should answer a simple question before making their investment decisions – do they really want to hedge against inflation? History teaches us that inflation is never a worry to investors during the bull market,since capital gains can always compensate their losses in purchasing power. Therefore,the current worry about inflation is mixed with worries about murky global economic outlook and bearish stock markets. As mutual funds are designed for long-term investors,investors should not regard inflation linked bond funds as a short-term safe haven in withering stock markets.

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About Author

YT Kum, CFA  YT Kum is a consultant for Morningstar, contributing to manager selection and asset allocation activities in Asia, and is responsible for providing investment thought leadership on topics relevent to investors in Asia.  

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