Feb. 5, 2011, 12:23 p.m. EST

How to Profit From Inflation

By Ben Levisohn and Jane J. Kim

Inflation,long a sleeping giant, is finally awakening. And that could present problems—along with opportunities—for investors.

A quick glance at the overall inflation numbers might suggest there is little reason to worry. The most recent U.S. Consumer Price Index was up just 1.5% over the past year. Not only was that lower than the historical average of about 3%, but it was uncomfortably low for Federal Reserve Chairman Ben Bernanke , who prefers to see inflation at about 2%.

What to Do Now Sell Cash and Bonds: Treasurys, long-term bonds Stocks: Financials, utilities and consumer staples Hard Assets: Gold, real estate Buy Cash and Bonds: Floating-rate funds, inflation-linked CDs Stocks: Small-company value stocks Hard Assets: Commodities, real-return funds

Yet it is a much different situation overseas, particularly in the developing world. In South Korea, the CPI rose at a 4.1% clip in January from a year earlier, higher than the 3.8% estimate. In Brazil, analysts expect prices to rise 5.6% this year, exceeding the central-bank target of 4.5%. China, meanwhile, has been boosting interest rates and raising bank capital requirements to keep inflation, which rose to 4.6% in December, in check.

"Emerging market economies are overheating," says Julia Coronado , chief economist for North America at BNP Paribas in New York. "They need to slow growth or inflation will become destabilizing."

Even some developed economies are seeing rising prices. Inflation in the U.K. surged to 3.7% in December, while the euro zone's rate climbed to 2.4% in January, the fastest rise since 2008.

Much of the uptick has been driven by commodity prices. During the past six months, oil has jumped 9%, copper has gained 36% and silver has shot up 56%. Agricultural products have soared as well: Cotton, wheat and soybeans have risen 100%, 24% and 42%, respectively. That's a problem because rising input prices "work their way down the food chain to CPI," says Alan Ruskin , global head of G-10 foreign-exchange strategy at Deutsche Bank (NYS:DB) .

Of course, the main inflation driver is usually wages—and that isn't a factor in the U.S., where high unemployment has kept a lid on pay for three years.

Yet there isn't a historical blueprint for the inflation scenario that seems to be unfolding now. Not only has the global economy changed drastically since the last big inflationary run during the 1970s, but the lingering effects of the recent debt crisis remain a wild card.

For investors, that means traditional inflation busters such as real estate and gold might not work as expected, while other strategies might perform better.

So how should you position your portfolio? The best approach, say advisers, is to tweak asset allocations rather than overhaul them. That involves dialing back on some kinds of bonds, stocks and commodities and increasing holdings of others. Here's a guide:

What to Sell

• Bonds. The price of a bond moves in the opposite direction of its yield. When inflation kicks up, interest rates usually move higher, pressuring bond prices. Even buy-and-hold investors get hurt, because higher inflation erodes the real value of the interest payments you receive and the principal you get back when the bond matures.

'There is no historical blueprint for the inflation scenario that seems to be unfolding now.'

The drop is usually most extreme in longer-dated bonds, because low yields are locked in for a longer period of time. So inflation-wary investors should shorten the maturities of their bonds, say advisers.

The safest bonds, especially Treasurys, are usually hardest hit, because those are the most influenced by changes in rates—unlike corporate bonds, whose prices also move based on credit quality. From September 1986 through September 1987, for example, as inflation moved higher, Treasurys dropped 1.2%.

It might even make sense to dial back on Treasury inflation-protected securities, whose principal and interest payments grow alongside the CPI. That's because investors already have flooded into TIPS, driving up prices and driving down the real, inflation-adjusted yields. A typical 10-year TIPS, for example, yields just 1.1% after inflation, compared with an average of more than 2% in recent years.

With so little cushion, long-term TIPS carry a higher risk of loss for investors who are forced to sell before the bonds mature. "Even if inflation is rising, you can still lose money," says Joseph Shatz , interest-rate strategist at Bank of America Merrill Lynch.

• Hard assets. Real estate may be a classic inflation hedge, but it seems likely to disappoint investors this time around. Even though rising inflation should put upward pressure on home prices, the twin forces of record-high foreclosures and consumers reducing their debt loads are expected to mute price gains for several years, says Milton Ezrati , senior economist at asset manager Lord Abbett. That's a far cry from the 1970s, when the median home price rose 43%, according to U.S. Census data.

Gold is another traditional inflation hedge that might be less effective now. With prices already having more than quadrupled over the past nine years, many strategists see substantial inflation already factored into the price.

Hot Commodities Commodities that are more closely tied to industrial or food production seem better positioned now than gold, say advisers.

Historically, gold has moved with the money supply. During the last 30 years, the correlation has been about 69%, according to FactSet data. (A correlation of 100% means two indexes move in lockstep all the time; a correlation of minus-100% means they move in perfect opposition.) Based on the money supply alone, gold is priced 25% above where it should be, says Russ Koesterich , chief investment strategist at BlackRock (NYS:BLK) Inc.'s iShares.

• Stocks. Equities can be a decent hedge against creeping inflation, because companies are better able to pass off costs to customers. But when input costs suddenly jump, profit margins take a hit.

At the same time, the higher interest rates that accompany inflation prompt investors to demand more profits for each dollar invested. As a result, price/earnings ratios tend to shrivel. Over the past 55 years, the average trailing P/E ratio of a stock in the Standard & Poor's 500-stock index has fallen to 16.95 during periods with inflation running between 3% and 5%, from 19.24 during periods with inflation of 1% to 3%, the most common inflation range since 1955, Mr. Koesterich says.

Sectors that are sensitive to interest rates, including financials, utility stocks and consumer staples, are especially vulnerable, say advisers.

What to Buy

• Cash and bank products. Money-market mutual funds are more attractive in inflationary environments because the funds invest in short-term securities that mature every 30 to 40 days, and therefore can pass through higher rates quickly. In an extreme example, money funds posted yields over 15% during the inflation-ravaged 1970s and early 1980s, says Pete Crane of Crane Data, which tracks the funds.

A growing number of inflation-linked savings products are cropping up as well. Incapital LLC, a Chicago investment bank, says it has seen a pickup recently in issuances of certificates of deposit designed for a rising-rate environment. Savers, for example, can invest in a 12-year CD whose rate starts at 3% then gradually steps up to 4.25% starting in 2015, and peaks at 5.5% starting at 2019 until the CD's maturity in 2023.

A caveat: If inflation eases and rates fall, investors could get burned, since the issuer may call the CDs and investors would lose out on the higher rates at maturity.

• Bonds. One way to reduce the impact of rising inflation on bond holdings is to build a bond ladder—buying bonds that mature in, say, two, four, six, eight and 10 years. As the shorter-term bonds mature, investors can reinvest the proceeds into longer-term bonds at higher rates.

"A bond ladder is best for someone who doesn't mind holding them for up to 10 years," says Jeff Feldman , an adviser in Rochester, N.Y.

Highly cautious investors might prefer the I Bond, a U.S. savings bond that earns interest based on a twice-yearly CPI adjustment. Although the current yield on I Bonds is only 0.74%, that yield is likely to move higher on May 1, the next time the rate is adjusted. I Bonds aren't as volatile as TIPS and appeal to conservative, buy-and-hold investors. The interest may also be tax-free for some families for education expenses.

25% Amount gold may be overpriced based on its relationship to the money supply.

More adventurous types might consider the inflation-protected government debt of other nations, which carry higher yields along with greater risks. The SPDR DB International Government Inflation-Protected Bond Fund (PSE:WIP) is an international inflation-protected bond exchange-traded fund designed to do well if inflation in overseas countries moves higher. The fund returned about 6.8% in 2010 and 18.5% in 2009, according to Morningstar (NAS:MORN) Inc.

• Bank-loan funds. Another way to exploit rising inflation is through mutual funds that buy adjustable-rate bank loans, many of which are used to finance leveraged corporate buyouts. So-called floating-rate funds are structured so that if interest rates rise, they collect more money. During periods of rising rates, floating-rate funds usually outperform other bond-fund categories. In 2003, for example, as investors anticipated higher interest rates and a stronger economy, bank-loan funds gained 10.4% while short-term bond funds gained 2.5%.

Now, amid expectations of rising inflation, investors are once again flocking to these funds, pouring in about $7.6 billion into loan funds in the fourth quarter of last year, according to Lipper Inc.—more than double the previous quarterly record set in 2007. The pace has accelerated this year, with investors putting in about $3.4 billion thus far.

After gaining almost 10% last year, the funds shouldn't be counted on for much price appreciation, says Craig Russ , who co-manages $22.7 billion of floating-rate investments across three floating-rate funds and other accounts at Eaton Vance Corp., including the Eaton Vance Floating Rate Fund (NAS:EVBLX) . But the funds generate plenty of income, yielding about 4% to 5% now, according to Morningstar.

Price Increases From Aug. 2, 2010 through Feb. 4, 2011:
  • Cotton: +100%

  • Silver: +50%

  • Soybeans: + 42%

  • Copper: +36%

  • Wheat: +24%

Be warned: Floating-rate funds can get creamed when investors fear the underlying loans are too risky. In 2008, for example, bank-loan funds lost 29.7%, although they zoomed 41.8% in 2009, according to Morningstar. What's more, banks are beginning to make riskier "covenant-light" loans that carry fewer stipulations for corporate borrowers—a sign of frothier trends in the market.

Given the potential for volatility, floating-rate funds are best viewed as a complement to—not a replacement for—investors' core bond holdings. Among Morningstar's picks in this category is the Fidelity Floating Rate High-Income Fund (NAS:FFRHX) , among the more conservative in the category.

• Commodities. Materials that are more closely tied to industrial or food production seem better positioned now than gold, say advisers. The trick is to find the best investment vehicle.

The easiest way for small investors to gain exposure to most commodities is through exchange-traded funds, many of which use futures contracts. But such funds can be dangerous because they often face "contango"—when the price for a future delivery is higher than the current price. The result: The ETFs lose money as they buy new contracts, even when prices are rising.

The losses can be extreme. In 2009, for instance, while the price of natural gas rose 3.4%, the United States Natural Gas Fund (PSE:UNG) lost 56.5% as a result of rolling over futures contracts.

Some firms have rolled out ETFs that aim to address the problem. One of Morningstar's picks is the U.S. Commodity Index Fund (PSE:USCI) , run by U.S. Commodity Funds LLC. The portfolio buys the seven commodities that are most "backwardated"—the opposite of "contango," so rolling contracts should result in a profit—along with the seven commodities with the most price momentum.

"USCI provides an outlet for investors who want broad commodities exposure but don't want to worry about the daily dynamics," says Tim Strauts , a Morningstar analyst.

Other funds play inflation by holding many different assets to protect against rising prices no matter where they show up. The IQ Real Return (PSE:CPI) ETF, launched in 2009 by IndexIQ, aims to provide a return equal to the CPI plus 2% to 3% over a two- to three-year period. To get there, it invests across a dozen or so inflation-sensitive assets—including currencies and commodities.

• Stocks. One corner of the market tends to do better when prices rise suddenly: small-company value stocks. "Because value and small stocks tend to be fairly highly [indebted] companies, inflation reduces their liabilities," says William Bernstein of Efficient Frontier Advisors LLC, an investment-advisory firm in Eastford, Conn.

From January 1965 through December 1980, for example, inflation averaged 6.6% a year. The Ibbotson Small-Cap Value Index posted average annual returns of 14.4%, according to Morningstar's Ibbotson Associates, double the S&P 500's 7.1% gain.

Morningstar's picks in the small-cap value fund category include Allianz NFJ Small Cap Value (NAS:PCVAX) , Diamond Hill Small Cap (NAS:DHSCX) , Perkins Small Cap Value (NAS:JDSAX) and Schneider Small Cap Value. Just be warned: Small value stocks have had a good run recently, returning 134%, on average, since March 6, 2009.

In the end, the particulars of any inflation-fighting plan may not be as important as developing a plan in the first place.

"The real problem you run into with any kind of inflation hedges," says Jay Hutchins, a financial adviser in Lebanon, N.H., "is that if you don't already have them when inflation is around the corner, you've missed the boat."

Write to Ben Levisohn at ben.levisohn@wsj.com and Jane J. Kim at jane.kim@wsj.com

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