Another ploy is to minimize U.S. government debt, says advisor Michael Boone of M.W. Boone and Associates in Bellevue, Wash. Treasuries are a pure interest-rate play, while the credit risk of corporate and municipal instruments reduces their sensitivity to rate changes.
However "the best insurance against rising rates is to bring in (shorten) the duration of the portfolio," says Bob Doll, president and chief investment officer of Merrill Lynch Investment Managers in Princeton, N.J. "We're generally a half year-and in some cases, a full year-below our benchmark," Doll says. At Stephens Capital Management, Tedford is keeping duration at 2.2 years, slightly above his permitted floor of 2.0 years and well below the current 3.4-year duration of his benchmark, the Lehman Brothers Intermediate Government Index.
Some advisors are using so-called inverse bond funds to hedge portfolios. These short the long T-bond (or create an equivalent economic position) at the market close each day in an attempt to capture change in the opposite direction. Rydex Juno Fund is among those that seek a one-to-one inverse move. Others are levered, such as the relatively new Rising Rates Opportunity ProFund, which aims for a 125% change opposite of price movement in the most recently issued long bond. Watch out for high expense ratios with this breed of fund, warns Eric Jacobson, a senior analyst at Morningstar.
Advisors with clients concerned about inflation must consider the latest options. U.S. Treasury inflation-protected securities (TIPS) are no longer the only game in town. Last year, Incapital LLC of Chicago began underwriting corporate-backed Inflation-Protected InterNotes. IPIs are unsecured (albeit investment grade) debt securities that sidestep the phantom tax problem which plagues TIPS and frequently lands them in tax-deferred accounts-not exactly at hand for investors seeking income. IPIs pay inflation-adjusted interest monthly while maintaining a constant principal value, whereas TIPS grow your principal for inflation, causing tax on the paper gain. However, issuance of IPIs has been limited since introduction.
Nervous nellies who demand Treasury-strength inflation instruments have a new choice in the Lehman TIPS Bond Fund, a Barclay's iShare exchange-traded fund introduced in December (under the clever ticker TIP). Its intention is tracking the Lehman Brothers U.S. Treasury Inflation Notes Index. With 20 basis points of expense, the new ETF is 0.02% cheaper than Vanguard's popular TIPS fund, although you also have to consider brokerage commissions with ETFs. Yet there is something to be gained from professional TIPS management-as long as you don't overpay for it-says Morningstar's Jacobson. "The TIPS market is small in terms of the number of (outstanding) issues, but it's a relatively inefficient market. The decisions that managers make can be important," Jacobson says.
Another way to profit in a potentially inflationary environment is to capitalize on changes in commodity prices. Funds such as PIMCO Commodity Real Return Strategy and Oppenheimer Real Asset attempt to mimic commodity indexes. Both enjoy "pretty good negative correlation" with the bond market, Boone says his research indicates.
While a rebounding economy unquestionably presents opportunities and challenges, it's important not to forget what the bear market taught: Diversification cushions total portfolio return. Yet some clients with short memories want to party like it's 1999, according to Dimitroff. "There are still people who are saying, 'Diversification is just going to slow us down,'" she says.
Don Phillips adds, "The mistake is not to come away with any valuable lessons from the last few years." Indeed, helping clients invest appropriately is the best way to profit, recovery or no.