How to fight inflation with absolute return

Putnam Investments, 5/29/13

One of the perennial concerns of investors is inflation, and for good reason. Inflation erodes one's purchasing power. That can leave investment returns - particularly returns that are largely composed of fixed-rate payments on government or corporate bonds - in a particularly vulnerable position. Recently, inflation has been low by historical standards, but it's worth watching. While inflation since 1913 has most commonly fallen between 1% and 2.5%, it has risen to anywhere between 2.5% and 11.5% close to 50% of the time in the past 100 years.

Inflation rates the United States today are still fairly benign, but it is important to note that inflationary pressures can build up over time. Experienced investors understand that inflation can have a corrosive effect on the buying power of a portfolio's returns, reducing the post-inflation, or "real," return.

Concerns about deflation - a systematic decline in the price of goods on the back of declining consumer demand - have also periodically emerged since 2008. Between dramatically rising and falling prices, the markets can feel beset by price uncertainty.

What does price uncertainty mean for portfolio strategy? Absolute return strategies typically have the flexibility to adjust to this tug-of-war between inflationary and deflationary forces by employing modern investment tools to seek to manage risk. By comparison, more traditional funds with broad exposure to either stock or bond markets might be more vulnerable to shifting inflation data.

For example, a traditional bond fund that is highly sensitive to interest-rate changes, such as a long-term U.S. Treasury fund, can suffer large declines if the market fears inflation, while an absolute return fund can use Treasury futures contracts to hedge out interest-rate risk. In addition, a traditional stock fund can be dealt a serious setback by a deflationary outlook, as deflation may depress lending and economic activity. By contrast, an absolute return strategy may commonly have the flexibility to avoid equities or to use index put options to hedge against the risk of downside volatility in stocks.

Currently, the economy is experiencing relative price stability. This condition could last, particularly if the economy experiences an increasingly steady growth rate. Alternatively, it could shift upward or downward - toward inflation or deflation. Absolute return strategies have investment tools to use in all of these scenarios to pursue their positive return targets while seeking less volatility than the markets.