How to protect yourself from the “monster under the bed”

In almost every fund update or piece of commentary, there are a handful of market themes which stubbornly rear their heads.

One of these is inflation. Investors have enjoyed favourable market conditions – such as relatively low inflation and even lower interest rates - since the global financial crisis. But, of course, nothing lasts forever. Inflation can be triggered by all kinds of factors, such as a rise in the price of oil, which pushes up the cost of goods and services, or wage growth, which means households are better off. So it's important to keep a close eye on it.

In fact, in a recent discussion with Fabrizi Quirighetti, who is co-head of multi-asset as SYZ, I was introduced to an excellent analogy for inflation.

“When you put your children to bed and you turn off the lights, they suddenly become very afraid that there are monsters under the bed,” he told me. “You can try and rationalise with them, and tell them that perhaps they have frightened themselves by seeing something about them on TV. But this doesn't usually work. When it comes to investors and inflation, I think it's a similar story,” he told me.

Any parents will know that it's difficult to get children soundly to sleep after a scare in the night. But sometimes, all it takes is a grown-up to come to the rescue, switch the lights on, and promise them that they will protect them from any unwelcome intruders.

By the same token, sometimes all it takes is a successful fund manager to fend off the potentially nasty impact of inflation on investors' money, so that they can sleep soundly at night.

Short duration bonds

For instance, while Fabrizi doesn't believe inflation will start rising rapidly in the near future, he believes it is important to always have some sort of hedge (a means of protection) in place. In his OYSTER Absolute Return fund, he will reduce the duration (time to maturity) of the bond section of his portfolio as and when he sees fit.

Rising inflation usually leads to rising interest rates. When interest rates go up, bond yields follow suit. This means newly issued bonds will be paying a higher coupon rate than bonds already in the market. So these older bonds become less attractive.

Short duration bonds are more liquid than their long-dated cousins. In a rising yield environment this is particularly advantageous, as it means the cash flows from frequently maturing bonds can be regularly re-invested at higher rates in the market.

Some 17% of Fabrizi's his portfolio is currently allocated to short-duration bonds, all of which are highly liquid. This means they can be sold quickly and easily. He says are predominantly there for asset class diversification, but will also be less susceptible to the effects of inflation because of their duration.

For investors who want to adopt a similar method, they could allocate a part of their portfolio to a fund which only invests in short-duration bonds, such as AXA Sterling Credit Short Duration. The fund, which is headed up by Nicolas Trindade, does exactly what it says on the tin: it buys short-term debt of high-quality companies, which will almost certainly will pay their yield and buy the bond back at face value. This minimises risk, provides income and protects against inflation.

Equity investing for the long term

For the higher-octane investor, or for investors who would want to balance out a low-risk portfolio with something punchier, equities are also a good option in terms of protecting against inflation.

Keith Wade, chief economist at Schroders, describes inflation is a “silent wealth killer”; his research shows that, if inflation were to average at 5% a year over 10 years, investors' £100 would be worth just £55.

He points out that many studies have proven that holding equities is one of the best ways to stay ahead of inflation over the long term. For instance, he highlighted the Barclays Equity Gilt Study showed that UK equities returned 5.1% per year on average over 118 years, compared to a 0.7% return from cash. This is a 'real' return which takes impact of inflation into account*.

One of Schroder's equity funds which sits on our Chelsea Selection list is Schroder Recovery, which may be a good option as part of a diversified portfolio. Managers Kevin Murphy and Nick Kirrage look for cheap companies which have suffered a price setback, but which they believe will turn themselves around and outperform over the long term.

Or of course, for investors who don't wish to decide their asset allocation for themselves, multi-asset portfolios are a good idea. Our VT Chelsea Cautious Managed Growth fund has a well-diversified portfolio of funds, all of which are chosen to provide investors with a positive absolute return while protecting investors' capital, regardless of the economic environment.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Lauren’s views are her own and do not constitute financial advice.

** Source: Schroders Insights. 1 May 2018. http://www.schroders.com/en/uk/adviser/insights/markets/the-silent-wealth-killer-how-quickly-would-inflation-erode-your-money/