Shield your portfolio from inflation

While attempting to beat inflation, a sound portfolio of equity, debt and other diversifiers should be tailored to suit one’s financial goals and risk appetite.

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Making sure your savings last a life-time is challenging enough. Added to this now is the possibility of one’s financial plans being thrown off-track by inflation.

Inflation, as most of us know, forces us to purchase less with the same amount of funds or pay more for the same purchase. If you thought this was reflected only in your monthly grocery and fuel bills, then sample this: Let’s say that in Decembe r 2007, you decided to save up for your child’s college education coming up in 10 years.

For a Rs 5-lakh course, factoring in an inflation of 4 per cent, you may have arrived at a neat sum of Rs 7.4 lakh at the end of 10 years. But is it the same now? Inflation at 8 per cent would mean your calculation has been thrown out of kilter; you would now have to budget for Rs 10.8 lakh! 

Inflation is one of the reasons for you to review or realign your financial goals as well as your portfolio. Here is a look at how you should factor inflation into your investments. This may, in turn, call for a change in your asset allocation and in the time/value of your financial goals. Also assessed are some of the traditional and emerging investment options that could help beat inflation.

Resetting goals

What rate of inflation should you expect? That should be the foremost question in setting a financial target. Says Mr Rajiv Anand, Head-Investments, Standard Chartered Mutual: “The 8 per cent inflation number presents a “rear view”. The inflation number captures what is already past. As a result of a high base effect this year, 2009 may possibly see inflation of 3-4 per cent.” For the future, he feels that 8 per cent inflation may not be sustained, but “inflation has certainly moved into a different orbit compared to the 2003 levels. Inflation of 5-6 per cent can be expected over a two-year cycle,” he says. This essentially means that while investors need to make a realistic estimate, they may need to reset the value of their targets based on the changed inflation scenario. 

This would also call for rebalancing the portfolio, in terms of enhancing exposure to investments with better return potential or diversifying to new asset classes such as gold and real estate, which perform well during inflationary periods.

Leading by miles

Equities have, time and again, proved to be the best defence against inflation. Higher inflation often results in increase in the price of manufactured products; this means better corporate profits and, thus, higher stock prices. The present tax-friendly environment for equities also strengthens the case for investing in stocks. So, if you don’t have any equity in your portfolio, consider adding some.

The Table shows the performance of equities and gold against inflation over the last eight years. Attaining long-term financial goals, whether buying a home, or saving for children’s education or retirement, may prove to be a Herculean task without at least a small allocation to equities. As Mr Mahadevan, CEO of investment advisory firm Wealth Advisors India, puts it “Equity is no longer considered an opportunity, it is a necessity” (see Table ‘Equity a Necessity’).

However, it should not be misconstrued that equity returns will always be propelled by inflationary pressures. If so, since January, when inflation has made itself quite conspicuous, the Sensex should have rallied instead of declining by 20 per cent. So, what went wrong?

One explanation could be that this bout of inflation has been driven by a steep rise in global prices of primary products such as materials and commodities that feed manufacturing, rather than in end products used by consumers. Thus, input prices have pressured company profitability, and therefore earnings, over the past few quarters. 

Going forward, whether inflation continues to take a toll on earnings or boosts them will depend on India Inc’s pricing power. If the demand environment turns out to be strong enough to allow price increases by producers, high inflation will eventually trickle down to earnings growth. However, a disproportionate spike in input prices which is not matched by end prices can impact corporate profitability.

Hence, companies in some sectors may be better equipped to handle inflation than others, calling for selectiveness in equity investing. A realistic assumption of equity returns (12-15 per cent annually over a five-year period) may also be required.

At present, we believe that larger companies with scale economies and access to funds are better equipped to handle input and borrowing cost pressures. Hence, a portfolio with higher large-cap exposure may be a better choice under the present inflationary conditions. For those not looking to invest actively, a portfolio of diversified funds with a large-cap bias should fit the bill. 

How should you rejig your debt investments to take care of inflation? Inflation is often accompanied by increases in interest rates, as the central bank tries to curb money supply to tamp down on rising prices.

Debt: the defensive bet

Locking into longer-term debt options may not the optimal choice at present as one might lose out on any favourable change in interest rates. In such a scenario liquid funds and fixed maturity plans with shorter maturing instruments would provide the option of moving to better interest rate regimes later.

Among mutual funds that focus on debt, funds such as DBS Chola MIP, Birla Sunlife Income and Standard Chartered Dynamic Bond Fund have done well over the past year. However, the call here may be to build a portfolio with a maturity period that suits the prevalent interest rate scenario. 

“Investors have to look at how dynamically the funds are managed. We have now shortened our portfolio maturity to 1-2 years” says Mr A. Balasubramanian, CIO, Birla Sunlife Mutual.

Debt should continue to be an integral part of any portfolio for two reasons: It offers capital protection and a regular cash flow. During downturns in the equity market, it is the debt component that minimises the shocks felt by your portfolio. The returns from balanced funds clearly shows how the debt component (although less than 30 per cent) has enabled the funds to decline less than the market in the volatile phase since January. For the tax-saving class, there are several debt options (see Table ‘Attractive tax saving debt options’) that offer the twin benefits of saving tax and building a debt portfolio to counter equity risks

A good number of them can also beat inflation, thanks to the tax benefits offered. For instance, the five-year tax-saving bank fixed deposits (assuming interest at 8.5 per cent) would provide an effective annual yield of 14 per cent if the interest were compounded annually and taxed at the end of maturity. Similarly, public provident fund is still effective by providing a yield of 10.6 per cent over 15 years (regular investing would enhance returns as the lock-in reduces during subsequent investments).

For senior citizens, apart from liquid funds and FMPs, the post-office senior citizens scheme would by far be the best option given the tax benefit available under Section 80C, effective April 2008. They could also consider locking into 1-year fixed deposits that offer interest rates as high as 10 per cent.

New proxy plays

Investors wanting to convert the present inflationary trend (of spike in inputs) into an opportunity may look at investing in commodities. Given the dearth of avenues for retail investors in commodities, you can consider the mutual fund route.

Magnum Comma Fund, a fund that invests only in stocks of commodity companies (now invested mainly in energy and metals), is well-placed to capture the spike in earnings growth of these companies on the back of a favourable commodity cycle. This fund, however calls for higher risk appetite as the performance is likely to be volatile. 

Similarly, gold, a well-known inflation-buster can now be acquired through the exchange traded fund route. For those looking to leverage on gold, investing in gold mining and producing companies may enhance returns.

For instance, DSPML World Gold Fund, which invests in companies in gold mining and marketing, has returned 13 per cent over the last month against the 8.6 per cent return by gold ETFs, which passively track gold. 

Real estate is another avenue to beat inflation. If you are looking at this asset class for investment purposes, (other than to live in), then real estate mutual funds, once launched, may provide an ideal option for retail investors. 

For those with a corpus in hand of at least Rs 20 lakh, real estate venture funds already provide a good avenue to invest in a professionally managed portfolio of real estate assets. These funds offer an array of options that provide capital appreciation as well as income in the form of dividends.

The above options should, however, be viewed as diversifiers that could enhance returns.

Rebalancing

While attempting to beat inflation, a sound portfolio of equity, debt and other diversifiers should be tailored to suit one’s financial goals and risk appetite. Here is where rebalancing one’s portfolio would play the key role. According to Mr Mahadevan, rebalancing need not always mean tweaking the equity and debt exposure alone; it could mean putting idle assets to better use. 

For instance, illiquid assets limit a person from unlocking the true value of their portfolio. “Unlocking the value of such assets and redeploying the surplus in asset classes that provide inflation-adjusted returns is a rebalancing act” he says.

Similarly, effectively deploying surplus lying in the savings account and quickly reinvesting dividends received would also help enhance the value of your money.