Better inflation hedge: TIPs or Wellesley?

[Rich_by_the_Bay]

Which do you think would be a better choice to hedge inflation: TIPs or a well-diversified income/dividend fund like Wellesley (65:35 bonds:dividend stocks)?

Assume a 3 to 4 year horizon meaning you could hold off withdrawing for that many years of inflation if necessary.

 

[wabmester]

A fund with 65% in nominal bonds would be almost the worst possible inflation hedge, but if your timeframe is only 3-4 years, I wouldn't worry too much about inflationary erosion.

 

[brewer12345]

Buy some 5 year TIPS.

 

[cute fuzzy bunny]

Well, here again we're looking at the fine mechanics rather than the function. My only trouble is with the time horizon. In less than 5 years, almost anything can happen. That having been said, I think we can say with some minor authority that basing from the current working environment, that substantially different CPI numbers over the next 5 years arent a huge probability.

Given that Wellesleys long term performance of exceeding the average CPI by 4-5%, that its a better buy LONG TERM than your garden variety inflation protected security.

For periods of 4-5 years...I'd go with a 5 year CD in the 6% range and leave it at that or stick with a money market.

 

[wabmester]

Given that Wellesleys long term performance of exceeding the average CPI by 4-5%, that its a better buy LONG TERM than your garden variety inflation protected security.

Interesting logic. Take a look at Vanguard's long-term bond fund, VWESX. Average return since inception (1973) was 8.79%, well above average inflation during that period. Does that mean that nominal bonds are a good inflation hedge? Of course not. Does that mean that people who buy bonds today should expect forward average returns to be near 8.79%? Of course not.

Past performance means little, and average past performance means even less. If you're looking for an inflation hedge, you probably want to look at how asset classes did in the face of increasing or high inflation. Nominal bonds did very poorly. Stocks didn't do so great either.

 

[mb]

I recall that the Wellesley manager stating that they usually performing particularly poorly during rising interest rates. I think that they have a fairly long duration.

 

[Rich_by_the_Bay]

Given that Wellesleys long term performance of exceeding the average CPI by 4-5%, that its a better buy LONG TERM than your garden variety inflation protected security.

That was the gist of my original question: given two generally conservative investments, is the guaranteed inflation-beating performance of TIPs outweighed by the otherwise far superior performance of a sound income-divident fund during non-inflationary conditions.

How long do inflationary flares last? If I give Wellesley a 5 year head start by assuming no rampant inflation for 5 years, TIPs would have to do VERY well to make that up during say a 2 year inflation in years 6 and 7.

Bottom line, I'm trying to decide whether to include TIPs in my fixed income piece, or just hold a little more Wellesley and take my chances. Either way, most will be in short term bonds and this is for the long end of my fixed holdings.

 

[brewer12345]

How long do inflationary flares last?

1966-1982. Do you feel lucky?

 

[REWahoo]

I couldn't locate annual performance numbers back any further than 1975, but just out of curiosity here's Wellesley annual returns for 75-82 vs the CPI for that year:

Return CPI
1982 23.3 6.1
1981 8.7 10.4
1980 11.9 13.5
1979 6.2 11.3
1978 3.6 7.7
1977 4.3 6.5
1976 23.3 5.8
1975 17.5 9.1

The five year stretch from 1977 through 1981 looks kinda rough...

 

[cute fuzzy bunny]

Ok wab, so historic data doesnt mean anything, so that leaves us with what?

 

[Rich_by_the_Bay]

The five year stretch from 1977 through 1981 looks kinda rough...

Interesting bad-case-scenario yet, even then, with the few years where W returned 7-15% better better than CPI, the final total may not be that much worse. If you can wait it out that long...

 

[brewer12345]

Interesting bad-case-scenario yet, even then, with the few years where W returned 7-15% better better than CPI, the final total may not be that much worse. If you can wait it out that long...

Uhuh, but look at the title of the thread: better inflation hedge. Not "which asset has a higher return?" When inflation spiked historically, it hasn't been all that great for Wellesley.

 

[Rich_by_the_Bay]

Uhuh, but look at the title of the thread: better inflation hedge. Not "which asset has a higher return?" When inflation spiked historically, it hasn't been all that great for Wellesley.

I guess that's right, but W seems good at preserving capital if nothing else.

I'm feeling like a couple year expenses in TIPs (at most) is wise, even if it puts a little drag on overall returns for the fixed income piece.

 

[wabmester]

Ok wab, so historic data doesnt mean anything, so that leaves us with what?

Only those "fine mechanics" that you so disdain.

Wellesley is 65% nominal bonds, right? Today, nominal bond yields are around 5%, and the embedded inflation estimate in those bonds is around 2.5%.

So, we don't need hyperinflation for nominal bonds to suck. If inflation goes up, that causes interest rates to go up, and bond values go down according to their duration. That's practically physics. If inflation stays above 3%, the total return on those bonds stay low relative to inflation-index bonds. In the case of high inflation, the total return on those bonds will be negative in real terms.

No historical data required. Use today's bond yields to predict future returns, use today's duration to predict capital loss and gain, use today's inflation estimate to predict effects of higher or lower inflation.

 

[jIMOh]

Which do you think would be a better choice to hedge inflation: TIPs or a well-diversified income/dividend fund like Wellesley (65:35 bonds:dividend stocks)?

Assume a 3 to 4 year horizon meaning you could hold off withdrawing for that many years of inflation if necessary.

If I needed to maintain purchasing power of money over 5 years, I'd look more to a fund like PRPFX, than Wellesley or TIPs. The prospectus of PRPFX suggests it's goal is to maintain purchasing power... if you look it owns commodities (gold, metals), stocks and bonds to make sure it has maintained purchasing power.

 

[trixs]

Honestly to protect against rapid inflation I would simply own 5% - 10% of a commodity index.

 

[Rich_by_the_Bay]

Honestly to protect against rapid inflation I would simply own 5% - 10% of a commodity index.

That makes sense on the protection side, but in between inflationary times, that's be quite a ride. I am pretty "capital preservation-oriented" in the draw down phase, I guess.

 

[trixs]

That makes sense on the protection side, but in between inflationary times, that's be quite a ride. I am pretty "capital preservation-oriented" in the draw down phase, I guess.

Oh just taking a look at something like DBC and you can see the wild ride heh.

However, what would something do to your portfolio that does not directly track stock prices? It will reduce volatility and smooth the ride. This could actually increase your returns because you buy low and sell high with reblanacing. :

Then again I might just be crazy!

 

[wabmester]

We're all trying to guess at the question Rich is really asking.

He's leaving us clues! My interpretation of what Rich really wants is potentially high upside with little or no downside. The holy grail of investing.

He seems to think Wellesley can provide that based on historical performance, and he's looking for confirmation that he is right.

IMHO, Wellesley is nothing but a fund with lots of nominal bonds and a smidgen of large value. The performance of that fund should be fine as long as the economy has solid growth and low inflation. Anything else, and all bets are off.

In the past 20-30 years, Wellesley has benefited from a few inputs that are no longer present (at least not to the same extent as they were):

1) High dividend yields on large value.

2) High bond yields.

3) A declining interest rate environment.

4) 2+ decades of speculative P/E growth.

If you believe that these ingredients still exist, then there's a fair chance that Wellesley will perform as well as it did in the past.

 

[unclemick]

Wellllllllllll

How about the choice between a bunch of civil service cats 'calculatiing' or Mr Market.

Kinda reminds one of a Dirty Harry movie or something - eh!

heh heh heh heh heh heh heh heh heh heh heh - 8).

And it's that time again folks! - Pssst Wellesley

That's my vote and I'm sticking to it. Even though I 'actually' own Target Retirement.

 

[cute fuzzy bunny]

Only those "fine mechanics" that you so disdain.

Wellesley is 65% nominal bonds, right? Today, nominal bond yields are around 5%, and the embedded inflation estimate in those bonds is around 2.5%.

So, we don't need hyperinflation for nominal bonds to suck. If inflation goes up, that causes interest rates to go up, and bond values go down according to their duration. That's practically physics. If inflation stays above 3%, the total return on those bonds stay low relative to inflation-index bonds. In the case of high inflation, the total return on those bonds will be negative in real terms.

No historical data required. Use today's bond yields to predict future returns, use today's duration to predict capital loss and gain, use today's inflation estimate to predict effects of higher or lower inflation.

I'm sorry, didnt know I 'disdained' anything in particular thats of value.

The problem with your analysis is that in the opposite scenario...low inflation, lowering rates, etc...the value of such a fund goes up. So plenty of ying to go with the yang.

As we've analyzed to death, the value of everyday non inflation protected bonds seems to be at a near parity with their inflation protected counterparts...it just takes a few years here or there. Efficient markets and all.

Since Wellesley doesnt hold long term bonds or even much in the longer intermediate area, its bond holdings should provide a medium holding term return thats compatible with a bunch of inflation protected bonds. And the chunk of large value just boosts the overall long term returns.

Once again, we're tied up with the semantics and mechanics and not the intent. Rich asked about a fund to hedge against inflation. Methinks a fund that returns an average of over 8% a year, has never had a double digit down year, nor any sequential losing years...and pays a dividend thats in excess of average CPI like clockwork...is a pretty good safe haven for money against inflation.

But if you like those inflation protected products that are paying less than a money market right now, and in some periods paying nothing at all...well...good for you!

 

[wabmester]

The problem with your analysis is that in the opposite scenario...low inflation, lowering rates, etc...the value of such a fund goes up. So plenty of ying to go with the yang.

He didn't ask for the opposite scenario -- he was asking about an inflation hedge.

The duration of Wellesley's bonds average 5.7 years. That means if interest rates go up (a la inflation), then the value of those bonds go down 5.7% for every 1% increase in market rates. I'm not sure if that's anybody's idea of an inflation hedge -- certainly not mine.

You simply cannot extrapolate the past performance of Wellesley into the future unless you also assume that the future economic environment and starting conditions are similar. I don't understand why people look to past performance when duration, current interest rates, current inflation, and current dividend yields are much better predictors of future performance.

The focus on past performance almost seems like a hairball sometimes.

 

[ats5g]

I couldn't locate annual performance numbers back any further than 1975, but just out of curiosity here's Wellesley annual returns for 75-82 vs the CPI for that year:

Return CPI
1982 23.3 6.1
1981 8.7 10.4
1980 11.9 13.5
1979 6.2 11.3
1978 3.6 7.7
1977 4.3 6.5
1976 23.3 5.8
1975 17.5 9.1

The five year stretch from 1977 through 1981 looks kinda rough...

For Wellesley from inception [7/1970] to 1994 see 12/31/94 Annual Report, page 6:

Return
1971 15.0
1972 9.7
1973 -3.5
1974 -6.4
1975 17.5

See also CPI-U. Shouldn't we be using Dec-Dec %'s? So 1975 would be [(55.5/51.9)-1] = 6.9%?

btw - Vanguard also breaks it down into Capital + Income Return, so you can see what both would have been from 1971-1982.

So, for example, the capital return for Wellesley from 1/1/71-12/31/82 was only around 0.30% per year, while the income return was around 8.86% per year.

- Alec

 

[pedorrero]

Devil's advocate:

1. TIPS may have inflation indexing built in, but how good is that? Indexed to a government index, CPI, PPI? One that is widely criticized as dramatically understating inflation over recent years? Tell me, has your health care, your food, your energy costs, risen at only 3% per year compounded? DId not think so. Why then, would you trust the government's inflation figures, or an investment linked thereto?

2. Where is your true inflation hedges (as a part of your total asset allocation) -- gold bullion, other precious metals, natural resources, real estate?

Put a gun to my head, and I'd vote for Wellesley, especially if it is a balanced fund? Forced to choose between 100% bonds and 100% equities, I'd take equities for their long term history. AT least you own a share of something real, not just a governmetn IOU.

 

[wabmester]

1. TIPS may have inflation indexing built in, but how good is that? Indexed to a government index, CPI, PPI? One that is widely criticized as dramatically understating inflation over recent years? Tell me, has your health care, your food, your energy costs, risen at only 3% per year compounded? DId not think so. Why then, would you trust the government's inflation figures, or an investment linked thereto?

We've beat this one to death elsewhere, but the bottom line is that CPI is a 100% transparent calculation, and the market watches the CPI, which is all that really matters. It doesn't matter if CPI matches your inflation rate. What matters is whether TIPS will preserve your purchasing power better than nominal bonds.

2. Where is your true inflation hedges (as a part of your total asset allocation) -- gold bullion, other precious metals, natural resources, real estate?

Those weren't allowed as choices in the original question. But of those, I like real estate as a true inflation hedge. Real estate prices are driven mostly by wage inflation, so when you give up your wages, it's nice to have something virtually guaranteed to keep up with the Joneses.