This mutual fund designed for inflation protection is trouncing stocks and bonds this year—here’s what it invests in

FAN Editor

Over the past year, inflation has put a major dent in Americans’ budgets and portfolios alike. Over the 12 months ending in August, the average cost of a basket of consumer goods rose 8.3%, with certain categories, such as food and gasoline, went up even faster, according to the Bureau of Labor Statistics.

As the Federal Reserve has embarked on a series of interest rate hikes to cool inflation, investors have had no place to hide. Bond prices, which move in the opposite direction of interest rates, fell by 12% over the one-year period ending in August. And investors worried that the Fed’s actions may tip the economy into a recession drove a nearly 16% drawdown in the stock market over the same period.

If you parked your money in cash, you haven’t been doing all that well either, points out Ford O’Neil, co-portfolio manager at the Fidelity Strategic Real Return Fund, a mutual fund strategy focused on shielding investors from inflation risk. “Even if you felt safe in a money market account and its value is unchanged, I can assure you the return is far below that of inflation you’ve experienced,” he says. “You actually have a negative real return.”

The fund O’Neil helps run is specially geared toward providing returns that outstrip the pace of inflation over 3- to 5-year periods. It’s no coincidence, given today’s high inflation, that its 2.7% 1-year return through August trounces the negative double-digit returns of stocks and bonds.

The specifics of this fund can reveal how professional investors go about fighting inflation and also how you can think about managing risk in your own portfolio strategy. Here’s a look at what’s inside.

This fund’s assets are designed to protect investors from inflation

To find which assets work best in a fund that seeks to outpace inflation, O’Neil and his co-managers examine various investments’ long-term rolling 12-month returns — a measure that allows analysts to see how consistently an investment performs — to see how often they tend to outpace the consumer price index.

The following four asset classes hold prominent positions in the fund and boast an above-average historical track record against inflation. The percentage next to each shows how often, based on rolling returns, the asset has beaten inflation from December 1973 through June 2022, according to data from Fidelity.

  • Floating rate debt (80%): Also called “bank loans,” these are loans that banks make to companies (usually low-quality ones). The interest rate on this debt is generally tied to a short-term benchmark which resets every 30 to 90 days. That means these bonds tend to preserve their value during periods of rising interest rates. In other words, when central banks hike rates to cool an inflationary economy, these bonds tend to benefit.
  • TIPS (75%): As the name suggests, Treasury inflation-protected securities are designed to protect bond investors from rising prices. Like Treasurys, these bonds are issued and backed by the U.S. government, but with an extra wrinkle: the bond’s principal value adjusts alongside inflation. TIPS pricing revolves around the “breakeven rate,” or the difference between the yield on TIPS and similarly dated Treasurys. The current 5-year rate of 2.33% suggests that if inflation averages more than 2.33% over the next five years, the 5-year TIPS would outperform the 5-year Treasury.
  • Real estate stocks (70%): “If you think about the elements that make up the CPI, the largest part is housing,” points out O’Neil. Real estate investment trusts — stocks in companies that own or operate income-producing real estate — tend to keep up with inflation because they enjoy pricing power. Companies that offer long-term leases generally bake inflation adjustments into their contracts, and short-term landlords are able to hike rents as housing prices rise.
  • Commodities (59%): Look at a list of the categories listed in the CPI, and you’ll see commodities everywhere, O’Neil points out. “Commodities are embedded in the CPI,” he says. “Think about utilities, gasoline, heating oil. Airline ticket prices are based on the price of jet fuel.”

Track records for beating inflation are mixed among the assets that the fund holds, and that’s sort of the point. By building a portfolio of investments that don’t move in lockstep, the managers are spreading their bets, knowing that performance for each will ebb and flow under different market conditions.

“Commodities had a challenging period following the global financial crisis, but they’ve more than made up for it in the last three years,” says O’Neil. “Real estate bounced back from a March 2020 lows, but on a 1-year basis, real estate is now faring poorly. “

Over the long-term, this well-diversified approach has proved greater than the sum of its parts. From December 1973 through June 2022, an asset mix similar to Strategic Real Return’s beat inflation 80% of the time.

When it comes to mitigating inflation — as is the case with tamping down on any kind of investing risk — you’re likely better off casting a wide net than opting for one investment you think could be a silver bullet, says O’Neil.

“You don’t know exactly when things are going to work. You have to give yourself multiple opportunities to win.”

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