Inflation-proof investing

May.01, 2008 in Market Outlook

Commentary: A portfolio to protect your returns

By Dr. Marvin Appel

Last Update: 12:01 AM ET May 1, 2008

GREAT NECK, N.Y. (MarketWatch) — Inflation has climbed to 4% this year — a
level not seen on a sustained basis in 17 years — while the U.S. dollar hovers
at record lows.

At the same time, the U.S. stock market remains in a correction, more than 10%
below its level from October 2007.

International stock markets have not fared much better in the past two quarters.
The yields on Treasury and other federal debt and on bank CDs, are lower than the
inflation rate.

As a result of all these developments, investors should be concerned about
whether their savings will be able to keep up with rising prices over the long
term.

You could hold Treasury Inflation-Protected Securities (TIPS) or Series I Savings
Bonds, which are guaranteed to stay ahead of inflation (before taxes). However,
the prospective returns from these inflation-indexed bonds are now too low to
generate the kinds of returns that most individuals would need to meet their
financial needs.

Rising commodity prices are now driving inflation and have been very profitable
in their own right in recent years, as have stocks in companies that produce
commodities. However, a limitation of such investments is their high volatility.
Here I describe a portfolio that has captured the benefits of the ongoing
commodity boom but which has been significantly less risky than either direct
investments in commodities or than the U.S. stock market.

The premise is that broad-based investments in countries whose economies depend
strongly on commodity production can give you favorable exposure when commodity
prices are strong, and a high degree of diversification to limit your risk when
inflation pressures are weak. The stock markets in stable, developed countries
such as Canada and Australia follow big trends in commodity prices, but can
dilute the volatility of a pure commodity-based strategy.

This inflation-proof portfolio has the added advantage of non-correlation with
the S&P 500 Index ($SPX). Non-correlation means that adding this mix of
investments to U.S. equity holdings might improve not only your returns, but also
the level of safety if past patterns repeat themselves.

The inflation-proof portfolio — equal dollar amounts in each of the following
eight investments.

Gold bullion ETFs (GLD)(IAU).

Broad-based commodity index ETFs (DJP).

Agricultural commodity index ETFs (JJA).

Canada ETF (EWC). The Canadian stock market represents commodity producers to a
large extent.

Pacific ex-Japan ETF (EPP). The countries most heavily represented are Australia
and New Zealand, also big commodity producers.

Permanent Portfolio Fund (PRPFX). This mutual fund has an inflation-oriented
portfolio that includes gold bullion and Swiss Francs. Its volatility has been
quite low.

First Eagle Global (SGENX).

First Eagle Overseas (SGOVX).

Historical results

The table to the right shows the year-by-year and overall compounded annual gain
and drawdown for the inflation-proof portfolio and the S&P 500 Index. Since the
ETFs listed as part of the portfolio are relatively new, I used the performance
of the underlying benchmarks (gold bullion, Dow Jones AIG Commodity Indexes, MSCI
Indexes) in their places to calculate the hypothetical past results.

There are three striking features in the data. First, the portfolio has beaten
the S&P 500 every year since 2000.

Second, the worst drawdown over the past fifteen years for the portfolio has been
only half that of the S&P 500. Indeed, the portfolio as a whole has also been far
safer than six of its eight individual components. (The worst drawdowns in
Canada, the MSCI Pacific-ex-Japan Index and in commodity price indexes have
ranged from 37% to 63% since 1993.)

Third, unfortunately, is that the inflation-proof portfolio did keep up with
stocks in the 1990s, when the stock market was very strong and the world
experienced disinflation.

Implications

Many investors are jumping into commodities in order to cash in on the boom or to
protect their purchasing power. However, in doing so they may be assuming an
unreasonable degree of investment risk. The portfolio presented here should
continue to thrive for as long as current economic trends remain in place, but
has been far safer than an investment directly in commodities or in the overall
U.S. stock market.

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