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Are inflation-linked funds a good bet?

Inflation has fallen from its peak in September last year, so are inflation-linked funds losing their appeal?

These funds aim to protect the value of capital and income from inflation by generating a return consistent with, or greater than, UK inflation. They often have exposure to inflation-linked bonds.

The UK consumer prices index reached a high of 5.2 per cent in September, according to figures from the Office for National Statistics. It has since halved to 2.4 per cent in June and 2.6 per cent in July.

The retail prices index also reached a high of 5.6 per cent in September. It has since fallen to 2.8 per cent in June and 3.2 per cent in July.

The attraction of inflation-linked funds depends on investors’ outlook for inflation.

Rowan Dartington head of collectives research Tim Cockerill says he does not see inflation as an issue over the short-term, but he expects the Bank of England’s quatitative easing programme will push inflation up over the longer term.

He says: “I do not see inflation as a big issue over the next 12 months. Once we perhaps get to a more normal footing of economic growth, we may see the impact of QE which is inflationary.”

Cockerill says it makes sense to have some inflation protection as a long-term strategy and adds he prefers bonds to multi-asset inflation-linked funds.

He says: “Index-linked bonds are one of the best ways to protect against inflation because your capital and your payments are insulated.”

Investec portfolio manager Max King, who runs the £25m Investec Diversified Growth fund, says the multi-asset approach is best.

He says: “Index-linked government bonds, conventional government bonds and investment grade bonds will not provide inflation-beating returns over the long term. Emerging debt, high yield and infrastructure funds are more likely to provide inflation-beating returns in the long term.”

King adds that index-linked government bonds are very expensive. He says: “They are particularly expensive at the short-dated end. At the long duration end, they only protect investors that hold them for the full term and you can lose a lot of money during the term.”

Kames Capital co-head of fixed income Stephen Jones, who runs the £267m Kames Inflation Linked fund, believes there is fair value in index-linked bonds.

He says: “They have under-performed, but that underperformance is now priced in. We think they are cheap enough to reflect lower economic growth towards the end of 2012.”

Jones says the sensitivity of long duration index-linked gilts to interest rate rises is not a concern.

He says: “The normalisation of interest rates is still some way off and so the demise of the index-linked market is some years off. When it does happen, it is crucial to have as flexible a fund structure as possible to hedge some of the interest rate risk that you have got, whether that is with futures or derivatives or investing in other assets.”

Hargreaves Lansdown head of research Mark Dampier agrees that index-linked gilts are cheap.

He says: “Index-linked gilts are cheap in comparison to nominal gilts which are only yielding 1.5 per cent and do not give you any protection against inflation at all.

“If you think inflation is going to soar to 6 or 7 per cent, then the only asset you want to temporarily hold is cash in order to retain the nominal value of the investment. The Bank of England would eventually be forced to put interest rates up and investors would make returns through that on cash, which would counter inflation.

”If interest rates go up a lot, then the price of index-linked bonds and equities could fall dramatically. A multi-asset inflation-linked vehicle would not help investors unless the manager goes completely into cash.”

Brooks Macdonald Asset Management investment manager Edward Park says that he prefers inflation-linked bond funds over the equivalent multi-asset fund.

He says: “We prefer to make the asset allocation call ourselves. We look for funds which are less benchmark aware as most of these funds can end up making large geographical bets and be dominated by new issues.

“In particular this can affect fund’s duration positioning and skew it to a level we might not be comfortable with.”

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