Chicago investors face higher risk to keep pace with inflation

Chicago-area investors are looking to shift their portfolios into higher gear—with greater risk—to keep pace with rising inflation.

The Standard & Poor's 500 and Dow Jones Industrial Average are in the red for 2008—down 4.6 percent and 3.0 percent respectively. Home prices have declined an average of 8.3 percent in the first quarter of 2008.

The Federal Reserve has slashed interest rates to combat the slowing economy, driving down the yields of fixed-income investments. With these three traditional investments stagnant, investors have few alternatives for their nest eggs.

Inflation, as measured by the Consumer Price Index, has increased for the past four months, with a 4.0 percent year-over-year increase in March.

“Anyone that has filled their gas tank or bought a carton of eggs is aware that prices are rising at a rapid clip,” said Christopher Davis, a fund manager with Morningstar Inc. He said the concern over inflation is “a lot more apparent this year.”

Where to turn?
Blue chip stocks have traditionally been one safe haven, but low returns this year have tempted investors to look elsewhere.

U.S. stocks averaged 11 percent annual returns from 1926 to 2001, according to The Vanguard Group Inc. But the Dow Jones Industrial Average, comprised of the 30 largest publicly held companies in the U.S., has averaged a 3 percent annual return since 2001.

Blue chip stocks, such as General Electric Co. and Boeing Co., are facing increasing competition from abroad, which has limited their ability to pass higher costs on to customers, said Carl M. Birkelbach, CEO of Birkelbach Investment Securities Inc. in Chicago.

“That was the old way of doing things,” Birkelbach said of investing in blue chips. Among large-cap stocks that still have potential for growth, he recommends Apple Inc. and Exxon Mobil Corp.

Despite Exxon’s $10.9 billion profit in the first quarter, Birkelbach pointed to the company’s P/E ratio of 11.55 as evidence that it is still reasonably priced. Both stocks are down this year, with Apple down 5.0 percent to $188.16 and Exxon down 4.0 percent to $89.19 Tuesday.

But Davis defended the blue chip stocks saying that lower prices represent a buying opportunity.“The large-cap blue chips have been ignored,” he added, by speculators who have turned to commodities to hedge against inflation.

“Hot, racy returns”
As the stock market has frustrated investors during the credit crisis, investors have increasingly turned to commodities—grains, metals and oil—to hedge against inflation, portfolio managers said.

“They’re looking for hot, racy returns,” Davis said.

Corn contracts in Chicago have risen 29 percent so far this year, and gold in New York has risen 5.4 percent. Crude oil’s notorious rise has driven up prices at the gas pump, but investors who caught the wave could have profited as much as 27 percent.

But many portfolio managers are wary of the commodity boom.

“This would be the first commodity bubble that wouldn’t end badly,” said Bruce Weininger, senior advisor with Kovitz Securities LLC in Chicago. He pointed to two periods in oil’s history—in 1995 and 1999—where similar supply and demand conditions drove up the price of oil. But within months, oil fell back close to its original price.

Birkelbach does not invest in commodities, but he offered an exchange-traded fund comprised of oil companies as a way to profit from oil’s rise without the speculative risk. ProShares Ultra Oil and Gas corresponds to twice the daily performance of the DJIA oil and gas index. It has increased 5.2 percent this year to $112.40.

For investors willing to take the risks, commodities offer “a real alternative” to the traditional investment opportunities, Davis said, but added, “they’re not screaming buys either.”

With some commodity prices now at record highs, Weininger said it is impossible to determine when the upward trend will reverse and said he has discouraged investors from “jumping on the commodity bandwagon.”

Uncle Sam offers help
Treasury inflation-protected securities, known as TIPS, offer the safest of safe investments. These securities work like bonds, but their coupon payments are adjusted every six months based on changes in the CPI. By their nature, these bonds are increasingly attractive to investors this year because of their one-two punch: Treasury security and inflation protection.

The interest in TIPS is evident in the rising availability of mutual funds and indexes that offer a package of inflation protection. Some of the securities invest exclusively in TIPS while others diversify with corporate bonds or mortgages.

Kenneth Volpert, senior portfolio manager at Vanguard, has seen the growth of the company’s Vanguard Inflation Protected Securities mutual fund. He said the fund, started in 2000 and one of the oldest TIPS funds available, has added $3.7 billion in investments this year, climbing to $16 billion in net asset value.

“It’s been a strong cash flow fund this year,” Volpert said.
The fund’s popularity has also been driven by aversion to corporate bonds, Volpert said, which have been hurt by declining yields and the perceived increase in risk.

Unlike commodities, TIPS are designed to give investors a hedge against inflation, and while commodities may have stronger short-term returns, they are not inherently inflation hedges, Volpert said.

Davis agreed that TIPS can be a sanctuary, but said as investors have sought safety, Treasury yields have fallen sharply and “don’t look very attractive.”

Going forward
Birkelbach is waiting for the economy’s “second shoe to fall.” He said that the economy on Wall Street is slowly recovering.

“There is a certain amount of relief,” he said.

As inflation continues upward and home prices continue to fall, Birkelbach said he wonders how the consumer will be affected.

For investors, Davis recommends a dollar-cost-averaging approach investment in stock mutual funds. Rather than investing large amounts in a fund all at once, a dollar-cost approach invests smaller increments at regular intervals. By choosing a mutual fund over an ETF, Davis says investors can save money by avoiding commission fees.

“It’s a way of avoiding timing the market,” he said, “by not putting all your money in at once.”

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