THE RIGHT MIX - How to make your investments inflation-proof

by SAMIR BIMAL




Iit were a living being, inflation would have felt flattered with the kind of attention it has been receiving lately from governments, institutions, industries and individuals. It is something which can act as both the reason or result of the ex- pected growth (or lack of it) of economies.

The expectation that inflation will rise in the future pushes up current prices. So one of the major objectives of the mone- tary policies in the recent past has been to control inflation ex- pectations. The initial inflationary pressure was predominantly conditioned by rising food and fuel prices, reflecting the effect of a deficient monsoon on agricultural output and increase in international crude prices. These coupled with strong econom- ic recovery created the ground for the Reserve Bank of India (RBI) to anchor inflation expectations.

Initially, RBI's inflation projection for March 2010 was 5.5%, which was revised to 6.5% in October 2009 and to 8.5% in Janu- ary 2010. The actual inflation figure was 9.9% in March. Now, RBI has an inflation target of 5.5% for March 2011. It is impor- tant to recognize that in the last decade, the average inflation rate had moderated to about 5% from the historical high of about 7.5%. As mentioned in the latest monetary policy, the con- duct of the monetary policy will continue to condition and con- tain perception of inflation in the range of 4-4.5%. This will be in line with the medium-term objective of 3% inflation consistent with India's broader integration into the global economy.

For the purpose of this note, let us limit ourselves to under- standing the effect of inflation on investments. But when we mention inflation, we will mean inflation expectation, as that is what would drive future payoffs. Also, investors expect higher returns to compensate for the higher expected inflation.

Different assets bear the impact of inflation differently. Value of all investments dip due to loss of purchasing power. Infla- tion, like taxes, is a cost and reduces the “real“ rate of return.

An investment portfolio should essentially address the objec- tives of returns, liquidity and ability to beat inflation, regular income and tax efficiency. Since it is rare to find all these in a single instrument, it is wise to have a diversified portfolio.

An inflation-proof portfolio would include long-term and short-term instruments, planned to generate a regular income stream and to make one's wealth grow. Investments in long- term instruments, too, should be done in a phased manner so that assets mature at different points of time.

While a specific investment plan would be unique to an in- vestor and needs to be customized, some portfolio pointers are shared here. On the fixed-income side, there are no inflation- linked bonds in India yet--bonds whose return are pegged to an inflation benchmark and rise with rising rates, such as Treasury Inflation Protected Security in the US. Conventional income products--savings, Public Provident Fund accounts, bank de- posits and debt mutual funds--would be subject to inflation risk but that can be mitigated to some extent by staggering invest- ments and maturity dates. A combination of some of the op- tions listed here would help you have a inflation-proof portfolio. Equity: It is an excellent way of managing inflation risk in a moderate inflation scenario. Whatever one's views on the short-term prospects of the market, a well-diversified portfolio of equity funds remains a good hedge against inflation. A monthly systematic investment plan in an index fund is the easiest way to do this. While short-term returns on equity may fluctuate, in the long run, appreciation in stock value can help combat the effects of inflation. Besides, reinvesting dividends is a good idea. Risk-averse investors may consider a capital-guar- anteed structured product, which provides 100% principal pro- tection with an equity upside.

Gold: The traditional hedge against inflation, gold as a quasi- currency does well when uncertainty goes up and vice-versa.
After March 2009, though the world economy has seen good re- covery, gold has not lost much value, indicating an undercur- rent that expects higher inflation as a by-product of economic recovery arising out of stimulus. In the recent past, exchange- traded funds (ETFs) have helped investors take a position on gold with minimum transaction cost and with least tax burden.

Commodities: Emerging economies, particularly India and China, will consume more energy and agricultural commodities for their growth. In this scenario, investors could look at going long on commodities. Investors in India can take advantage of the overseas investment facility to buy agricultural and oil com- modity ETFs abroad. Energy and food are the major compo- nents of an inflation index. Hence, one must look at hedging oneself by looking at ways to buy into these commodities.

Real estate: This offers a potential hedge against inflation. As the gross domestic product is expected to grow at 7% plus, in- flationary pressures should drive up property prices in the fu- ture. You can also invest in real estate funds. These are similar to equity funds and allow investors to spread their risk by pool- ing their assets with other investors to purchase commercial properties, which are then rented out to businesses. These funds offer investors high yields from the rental income they make and capital appreciation at the end of the term.

As mentioned above, along with inflation, tax management aspects needs to be considered in a portfolio. Going forward, watch for changes in investment taxes based on the proposed Direct Taxes Code. It could affect the tax treatment of capital gain and dividends, among other things. If that happens, you may need to review your investment mix. The portfolio con- structed using the options discussed, with proper asset alloca- tion, would be balanced, inflation-proof and risk-resistant.

Samir Bimal is country head, private banking (India), ING Vysya Bank Ltd.