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How to Protect Your Portfolio With 'Real' Assets

Rachel Koning Beals

It's a lingering fear of deflation (the inability of businesses to raise prices) that prompts the U.S. Federal Reserve and its global central bank counterparts to keep interest rates pinned at historic lows, for an historic length of time. Eventually, policymakers will have to move from this stance.

For those at the economic controls and the investors trying to anticipate what's next, timing can be everything. Inflation can stymie a recovery and once it has crept in, it can be hard to squeeze out.

[See What Could Go Right (and Wrong) for the Economy in 2012.]

Buying a little inflation protection for individual portfolios may not be the cheapest insurance policy right now. Nonetheless, it's insurance some believe is crucial.

Portfolio managers Cohen & Steers launched a diversified real assets strategy earlier this year. They feel inflation is destined to move higher due to aggressive global monetary stimulus, growth in emerging markets, and barriers to production of key natural and agricultural resources. Yigal Jhirad, a senior portfolio manager at the firm, suggests a 10 percent to 20 percent portfolio slice be dedicated to inflation-fighting real assets, depending on an investor's risk profile, investment goals, and other factors.

Sure, folding in commodities and real estate exposure can insulate a portfolio against inflation, but proponents argue that there's an added benefit: Real assets have had a solid track record of historical returns and they provide diversification that's noncorrelated to stocks, which can potentially maximize overall performance. They can also fold in global economic exposure without the risk and cost of direct investment in overseas stocks.

Over the past few years, prices for commodities like gold, energy, and agricultural products have moved sharply higher. Some observers see this as a harbinger of greater inflation to come; others dismiss the rise as more transitory. They believe the spike simply drives prices out of reach.

Said Cohen & Steers in a recent investor publication: "This latter view is supported by an overhang of slowing economic growth, as developed markets work through a variety of debt and fiscal challenges. But it is not supported by the everyday experience of the American consumer, saddled with rising prices for food and energy."

[See 3 Investments to Fight Inflation.]

Investors are bombarded with a mixed message about economic risks, especially in the near- to medium-term.

Data from the Commodity Futures Trading Commission, which regulates futures trading on commodities, showed that hedge funds and other large money managers scaled back bullish positioning in commodities in late March. The Standard & Poor's GSCI Spot Index of 24 raw materials fell more than 2 percent as March came to a close, trimming its advance so far this year to 6.8 percent. Goldman Sachs cut its three-month commodities recommendation in a note dated March 28, saying targets had been met and warning that the global economy will soften in the near term. Societe Generale and other investment banks have issued research notes warning about stalling Chinese corporate profits. European debt rescue efforts continue.

Goldman Sachs does maintain its call for higher gold and raw materials prices over time. While raw materials may drop or be little changed in the near term, they will probably gain 10 percent over the next 12 months, the analysts said in the research note. Goldman's target for crude oil is $123.50 a barrel, 20 percent higher than where it stood March 30. Gold may reach $1,940 an ounce, up 16 percent.

Then the Fed weighs in, again: "Inflation has been subdued in recent months although prices of crude oil and gasoline have increased lately," the Federal Open Market Committee said in a statement following a March 13 meeting. Oil will "push up inflation temporarily, but the committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate" of stable prices and maximum employment.

Investors must sift through the short-term noise and ask themselves some hard questions about inflation risk.

Five themes drive the Cohen & Steers investing position:

-- The consumer price index (CPI), the commonly used benchmark, misses some key portions of the overall economy. CPI rose 0.4 percent in February due to a jump in gasoline prices, a figure in line with estimates. The core rate (excluding food and energy) rose a less-than-expected 0.1 percent. Cohen & Steers says the true rate of inflation is likely better reflected by adding 400 basis points to the CPI.

-- Emerging market commodity consumption is not given enough weight in the global inflation picture. Emerging markets' share of the global economy is some 40 percent, up from 20 percent just 10 years ago

-- Changing macroeconomic conditions and pricing uncertainty in the current climate demand greater portfolio diversification

-- Tangible assets including commodities, natural resource equities, and real estate should form the core of a diversified real assets strategy. Treasury Inflation Protected Securities (TIPs), partly because of their CPI link, don't offer enough protection

-- Global interconnectedness will speed the transfer of inflation.

[See ETF Basics: How to Invest in Commodities.]

Get real with REITs. One way to add a "real" component to your portfolio is through land, a finite investment. Investors who don't want the responsibility of physical property ownership may opt to gain exposure through real estate investment trusts (REITs). Tax-law changes hit this sector a few years ago but their popularity, in large part because of their dividend attributes, is on the rise again. REITs are typically most effective in tax-advantaged accounts such as IRAs or 401(k)s where their nonqualified dividends are shielded from Uncle Sam.

Importantly, as the 2008 crash showed, correlation between REITs and stocks has narrowed. But they may still hold an important role in diversification (not to mention income generation), according to Morningstar's Adam Zoll.

The industry trade group National Association of Real Estate Investment Trusts (NAREIT) claims that a hypothetical portfolio consisting of 50 percent core funds, 30 percent REITs, and 20 percent opportunity funds would have delivered 10 to 20 percent average annual returns in nearly 60 percent of rolling five-year holding periods over the past 22 years through last year. In the remaining 40 percent of rolling five-year holding periods, this portfolio would have produced single-digit annual returns.

Critics say there can be shorter-term negatives that can damage portfolios. For instance, REITs typically work as an inflation hedge only when property markets are in balance. Supply overhang of commercial properties can reduce the effectiveness of REITs as an inflation hedge. Large periods of capital market investment are often followed by excess supply and idle properties. Investors are wise to distinguish between their longer-term inflation hedging needs and their shorter-term needs.

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