How to Protect Your Portfolio With 'Real' Assets

Assets such as gold, energy, and real estate can keep your portfolio ahead of inflation.

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Investors must sift through the short-term noise and ask themselves some hard questions about inflation risk.

Five themes drive the Cohen & Steers investing position:

• The consumer price index (CPI), the commonly used benchmark, misses some key portions of the overall economy. CPI rose 0.4 percent in February due to a jump in gasoline prices, a figure in line with estimates. The core rate (excluding food and energy) rose a less-than-expected 0.1 percent. Cohen & Steers says the true rate of inflation is likely better reflected by adding 400 basis points to the CPI.

• Emerging market commodity consumption is not given enough weight in the global inflation picture. Emerging markets' share of the global economy is some 40 percent, up from 20 percent just 10 years ago

• Changing macroeconomic conditions and pricing uncertainty in the current climate demand greater portfolio diversification

• Tangible assets including commodities, natural resource equities, and real estate should form the core of a diversified real assets strategy. Treasury Inflation Protected Securities (TIPs), partly because of their CPI link, don't offer enough protection

• Global interconnectedness will speed the transfer of inflation.

[See ETF Basics: How to Invest in Commodities.]

Get real with REITs. One way to add a "real" component to your portfolio is through land, a finite investment. Investors who don't want the responsibility of physical property ownership may opt to gain exposure through real estate investment trusts (REITs). Tax-law changes hit this sector a few years ago but their popularity, in large part because of their dividend attributes, is on the rise again. REITs are typically most effective in tax-advantaged accounts such as IRAs or 401(k)s where their nonqualified dividends are shielded from Uncle Sam.

Importantly, as the 2008 crash showed, correlation between REITs and stocks has narrowed. But they may still hold an important role in diversification (not to mention income generation), according to Morningstar's Adam Zoll.

The industry trade group National Association of Real Estate Investment Trusts (NAREIT) claims that a hypothetical portfolio consisting of 50 percent core funds, 30 percent REITs, and 20 percent opportunity funds would have delivered 10 to 20 percent average annual returns in nearly 60 percent of rolling five-year holding periods over the past 22 years through last year. In the remaining 40 percent of rolling five-year holding periods, this portfolio would have produced single-digit annual returns.

Critics say there can be shorter-term negatives that can damage portfolios. For instance, REITs typically work as an inflation hedge only when property markets are in balance. Supply overhang of commercial properties can reduce the effectiveness of REITs as an inflation hedge. Large periods of capital market investment are often followed by excess supply and idle properties. Investors are wise to distinguish between their longer-term inflation hedging needs and their shorter-term needs.