Inflation, what inflation? Of all the risks that can harm our investments, inflation is probably one that few people are thinking about right now.
And who could blame investors for this? It’s not as if they don’t have enough on their minds already with the global pandemic. And surely, with unemployment expected to go up and wage growth to at best stagnate we’re not going to be encouraged to spend much. That should keep inflationary pressures at bay, right?
Probably so, at least for the time being. But protecting against inflationary risks is not something we should think about only when prices are already on their way up. In fact, protecting your portfolio against a risk only when the risk has morphed into a reality is kind of self-defeating.
Buffeting your portfolio against the insidious effects of inflation is one of the key tenets for successful investing. You don’t want to see your hard-earned returns eaten away by what is, in effect, a stealth tax. And with central banks and governments around the world going all guns blazing to support the economy, there is a risk that inflation may rear its ugly head further down the line.
The Bank of England has acknowledged for the first time that negative interest rates are a tool in the box, even if it is not yet being used. Other central banks around the world – for example the US Federal Reserve – are talking openly about flexible inflation targets. In simple terms: to support the economy, the Fed will be happy to see inflation going above what has traditionally been considered an acceptable level – typically 2% - without intervening.
So while you may not see inflation right now, it would be unwise not to ignore that it is being actively touted as the “price to pay” to get the economy back up again.
How to Protect Your Portfolio from Inflation
The basic building block of an inflation-fighting strategy is inflation-linked bonds. The coupon for these bonds is made up of a fixed and a variable component linked to an inflation index. In the case of bonds issued by the UK government, it is the Retail Price Index (RPI).
Passive funds - both exchange-traded-funds (ETFs) and traditional index funds – offer investors easy access to this segment of the bond market. Besides, as an inflation-fighting strategy is best deployed as a permanent feature of an investment portfolio, their low-cost help to keep running expenses in check.
The iShares GBP Index-Linked Gilts (INXG) is a market-leading ETF with an ongoing charge of just 0.10%. This was cut from 0.25% in May 2019. The ETF tracks the Bloomberg Barclays UK Government Inflation-Linked Bond Index.
L&G All Stocks Index-Linked Gilt Index fund is also a market-leading traditional index fund that may appeal to investors unwilling to use ETFs. This index fund replicates the FTSE Actuaries Index-Linked All Stocks Total Return Index and comes with an ongoing charge of 0.15% for its clean retail share class.
There are no meaningful differences between the indices tracked by these two passive funds, and both have been assigned a Morningstar Analyst Rating of Bronze.
Investors in UK inflation-linked bonds should be aware that issuance of UK government bonds is structurally biased to very long-dated maturities. This means that indices for this market – and thus the passive funds tracking them- come with very high duration; typically, above 20 years.
Very high duration is a nice tailwind to have at times of interest rates cuts but could cause a drag in performance in the opposite scenario. Still, as these should be buy-and-hold holdings in your portfolio, the ups and downs in valuations in relation to changes in interest rates may balance themselves out over the long term. This makes the issue of keeping running costs crucial and this is where passive funds have a significant advantage.
