By Brad Case

Inflation has always been a troubling factor that haunts investors when seeking balance in their portfolios. For example, from 1993 through 2006, consumer price inflation in the U.S. averaged a sedate 2.5 percent per year. During 2007, that average inflation rate jumped by 60 percent to 4 percent per year. Time for investors to panic? Hardly. However, that jump in inflation, and widespread concerns that it may increase in coming years, have prompted investors to consider inflation hedges.

An inflation hedge is simple: if the inflation rate increases, then investors want an investment whose returns increase, too—and at roughly the same time. For example, when the prices of food, fuel, health care and other consumer purchases go up, so does the balance in an investor's inflation-hedged portfolio.

Having an inflation hedge is especially important for retirees, because a temporary increase in inflation that's not matched by an increase in investment returns can erode their wealth. An unhedged surge of inflation—like an unexpected rush of medical expenses—can bring retired investors perilously close to financial ruin.

Fortunately, there are several assets that investors have traditionally looked to as inflation hedges, including Treasury inflation-protected securities (TIPS), commodities and real estate. However, if the idea of an inflation hedge is simple, it's surprisingly difficult to determine which assets are dependable enough to protect investors. Investors selecting inflation-hedging assets must understand and confront several tradeoffs, such as the return on the inflation hedge, its volatility and the timing of its protection.

TIPS: Timing Isn't Everything

The U.S. government started to sell TIPS in 1997. They provide the surest protection against inflation by building the inflation rate right into the income earned on a U.S. Treasury bond. Every six months, the government adjusts the principal on the bond according to the measured level of the consumer price index as of that date. The investor then receives an interest payment equal to the adjusted principal multiplied by one-half the stated annual interest rate (which is determined by auction when the bond is originally issued).

Therefore, the income from TIPS completely covers the effects of inflation. However, it doesn't mean that TIPS are a perfect inflation hedge, because income is adjusted and paid only every six months. Therefore, there's a lag between any rise in prices and the increase in income that will eventually match it.

Returns During Months of Higher-Than-Average Inflation

Source: IDP and FactSet

Aside from maturity risk, TIPS are one of the safest investments, because they're backed by the full faith and credit of the U.S. government and provide additional protection against inflation. However, that kind of security comes with a price in the form of lower returns. The total return to TIPS is approximately 7.25 percent per year, above the rate of inflation, but 110 basis points less than the total return on non-inflation linked bonds with similar maturity.

Investors should also note that TIPS are traded actively, and their total return—the sum of their income yield and the change in their value on the open market—typically fluctuates independently of the inflation rate.

However, retirees typically reach into their total portfolio wealth at approximately 5 percent per year to cover current expenses, and TIPS can't provide income at that level. In the end, retirees generally shouldn't count on TIPS as the only inflation hedge in their investment arsenal: they also need assets that will provide higher returns.

Commodities: No Guarantees

One of the higher-return weapons that investors have looked to for inflation hedging is commodities, especially precious metals, such as gold and silver; industrial metals, such as aluminum and copper; and petroleum products, such as crude oil and natural gas.

Commodities are a natural inflation hedge because changes in commodity prices are an important component of the inflation rate. They contribute directly to rising household expenses because consumers must pay the higher prices for goods such as gasoline and heating oil, as well as indirectly when producers pass on changes in raw material prices to consumers.

Commodity investments aren't a guaranteed inflation hedge, but they have two advantages over TIPS. The first is the return, which is generally higher than the 7.25 percent per year total return for TIPS.

Secondly, there's little lag between a jump in prices and an increase in commodity returns. In fact, commodity returns often lead inflation, because commodity prices are such an important component of the overall price level.

That means that commodities provide something that TIPS don't: higher wealth before a retiree needs to tap into the investment portfolio to fund higher expenses. However, this hedging ability comes at a cost: extreme volatility.

Indeed, commodity returns are more volatile than almost any sector of the stock market. The standard deviation of monthly returns has been approximately 4.4 percent for precious metals, 5.4 percent for industrial metals and 8.5 percent for petroleum over the past 15 years, compared to 3.9 percent for the S&P 500, 4.0 percent for the Dow Jones Wilshire 5000 and 1.5 percent for TIPS. That kind of volatility is why many retirees shy away from commodity investments.

REITs: Higher Risk-Adjusted Returns

The third weapon in the inflation-hedging arsenal is commercial real estate. Like commodities, income-producing real estate is a natural inflation hedge because changes in the consumer price index are factored into rent increases. For example, retail and office leases typically include an automatic escalation clause protecting the landlord from inflation during the life of the lease. That type of provision is less common in apartment leases because they are typically much shorter, so rents are adjusted between leases to keep up with inflation.

Because leases are structured so that rents adjust to changes in measured price indexes, real estate returns typically lag inflation changes.

Returns During Months of Lower-Than-Average Inflation

Source: IDP and FactSet

Like commodities, REITs also provide much higher returns than TIPS. For example, the total return on equity REITs over the past 15 years has averaged 13.2 percent per year—10.3 percent above the average inflation rate. However, REITs shine brightest as an inflation hedge because of their risk-adjusted return.

REITs are only about as volatile as stocks, and the Sharpe ratio for equity REITs has been 1.59, greater than any commodity index. For example, the Sharpe ratio for industrial metals has been 0.52. Even the best-performing commodity, petroleum, had a Sharpe ratio of 0.92, comparable to the stock market, but falling far short of the risk-adjusted performance of REITs.

Covering Inflation: The Bottom Line

For inflation-wary investors, the bottom line is whether investments are going to cover the loss in purchasing power when prices jump.

For retirees who must dip into principal to fund some current expenses, the question is whether total returns—rather than just income—will cover losses in purchasing power. TIPS accomplish this: monthly total returns cover one-month price increases 67 percent of the time, and six-month returns cover six-month price increases 84 percent of the time. REITs aren't as sure of a bet on a total returns basis, but they are still strong: monthly total returns covered same-month price increases 54 percent of the time, and six-month total returns covered six-month price increases 73 percent of the time.

However, commodities have been less certain to cover inflation on a total-return basis. Monthly total returns on industrial metals, for example, covered same-month price increases 52 percent of the time, while six-month total returns covered six-month price increases only 60 percent of the time.

So, what parts should TIPS, commodities and inflation play in the investment portfolio of an inflation-wary investor? All three assets have their champions. However, investors should keep in mind that REITs have substantially outperformed TIPS and stocks when inflation was higher than average. Additionally, REITs still substantially outperformed TIPS, far outpaced metals and weren't much off the pace set by stocks when inflation was lower than average.

Only one inflation hedge has performed well in both high-inflation months and low-inflation months, and only one inflation hedge combines strong returns with moderate volatility to offer superior risk-adjusted performance. That inflation hedge is REITs.

Brad Case is NAREIT's vice president, research and industry information.