As the stock markets continue to recover (assuming it has not done yet), the talk of inflation is coming back in the news. Our government has pumped in so much of printed money in the system that there is a concern that US economy will experience inflationary times. There is no denying that inflation will take away chunk of our real returns from overall investing returns.

Many of the well known economists and investors (including Warren Buffett) have expressed concerns about inflation. Among all the experts and pundits, I believe, David Swensen gave a very pragmatic and down to earth response to this question in an interview on WealthTrack. According to Swensen, he does not know what will happen. He cannot predict it. There will be inflation if the recent pumping of money supports the economy and growth returns to US economy. If there is no growth, then there will be deflation of dollar value. His message was to address these issues with proper diversification and asset allocation. As individual investors what can we do to (or rather how can we) blunt the effect of inflation or deflation. Following are five aspects one can look into to manage their asset diversification.

• First, include Treasury Inflation Protected Securities (TIPS) in your portfolio. As an example, one can consider simple US Treasury based bond fund like iShares Barclays TIPs (TIP) to offset this risk. It also has low operating expenses of 0.2%.
• Second, include gold commodity as an asset in your portfolio. I believe one should hold physical gold in some form (like coins, bars, jeweler, etc). There is no point in holding those gold derivatives which can easily be manipulated. Furthermore, most of the world currencies are now completely detached from gold standard. So I would really question the notion that gold remains an inflation hedge. I tend to believe gold is an excellent hedge against any short to intermediate term crisis like currency issues, sovereignty issues, etc. It is important not to go crazy and binge on gold, but maintain an asset allocation that you are comfortable with.
• Third, include dividend paying stocks in your portfolio for companies that are doing business in commodities. These companies are able to increase prices of their products as price of raw commodities increase. Examples of such companies are ADM, EEP, KMP, BP, XOM, CLX, MCD, utilities, etc. These types of companies are less susceptible to inflationary environment.
• Fourth, include dividend paying stocks of US based or developed country multinational companies that derive significant chunk of their earnings from emerging markets. As inflation erodes dollar value, currencies from other countries can provide the fill up to their earnings.
• Fifth, include emerging market ETFs (stocks or bonds) in your portfolio. It is important to look for ETFs that are based on individual markets, denominated in local currency, and essentially captures a wider market base. The simple way to start your allocation using VWO or EEM, which are broad based. After that look for individual country ETFs. In my opinion, all those ETFs and funds that hold dollar denominated ADR and ADS does not provide hedge against the dollar inflation/deflation.

The message here is that maintaining a diversified asset allocation should be simple and easy to understand. What’s the point in investing in those confusing derivatives and linked to futures (commodity or currency) which are difficult to understand.

What is approach to this issue? How do you plan to address it in your portfolio?

This article was first published at The DIV-Net on October 1, 2009.

One of basic tenets of portfolio construction is following the principles of asset allocation. This is much more applicable and valid for do-it-yourself individual investors. In this context, at a minimum, I need to look at and at least consider evaluating all possible asset classes. While doing this, I also have to keep in mind that my portfolio is based on dividend growth philosophy. Among others, a commodity is also one asset class which I believe I should be investing. The next question is what should be my investing vehicle.

Since 2001, quite a few commodity index based Exchange Trade Funds (ETF) and Exchange Traded Notes (ETN) were introduced in the market. There are more than 30 commodity ETFs/ETNs of various flavors based on agriculture, raw metals, coal, water, oil, natural gas, gold, silver, different combinations of these in index format, etc. And how can we forget, the biggest sham of all investment vehicles, futures-based index ETFs/ETNs. My viewpoint is, futures-based index are just designed for speculation. As it always happens, during the speculative boom of late 2007 and early 2008, every month a commodity ETF or ETN was launched in market in one form or other.

As an individual investor I need to understand how these different forms of investment vehicles fit into my portfolio, what my expectation is, and what is my objective for investment in them. Not all commodity ETFs and ETNs are created equal. And as with any other investment vehicle, what is the price I am willing to pay.

In general, across many index-based ETF/ETN, I find that almost 25% to 30% of weight is occupied by usual suspects of 10 to 15 companies. At the height of commodity boom between late 2007 and mid 2008, MON, POT, BHP, RIO, RTP, SLB, and few big oil companies were in almost every other ETF/ETN. Being a dividend growth investor, when I look at this menu of ETF and ETN choices, I do not find a single investment as a worthy investment. In their current form and constituents, these commodity ETFs/ETNs do not meet my objectives and hence have no role to play in my portfolio. Perhaps they will never be unless there is any change in construction of these ETF/ETNs.

However, I do want to own commodity as an asset class. So I like to invest in corporations that do business in commodity extraction, processing, marketing, etc. These are very good proxy for investing in commodity asset class. There are quite a few corporations that have profitable business models in almost all types of commodity business. One of the characteristics of almost all commodity businesses is that it is a very cyclical in nature. I believe that’s where the opportunity lies for dividend growth investor. Knowing that business is cyclic, we need to look for corporations that manage it around this constraint. Consistency and/or growth in dividends is a perfect measure for this aspect.

I am currently invested in BP (for oil), NUE (for steel), and DBN (materials).

In addition, following is the shortlist that I am watching and studying for my dividend growth portfolio.

• Chemicals (DD, DOW, PX, IFF, ARJ, TNH);
• Agriculture (ADM, MON, BG, AGU);
• Oil (SLB, XOM, CVX);
• Coal (ACI);
• Iron ore (BBL);
• Steel/Iron (GNI, RTP); and
• Gold (RGLD).

While it is true that not all pay consistently growing dividends, but that’s the case in all sectors. As a dividend growth investor, I need to pick those that I think best suits my portfolio objective.

What this shows is there are so many corporations in commodity business, that dividend investors can easily avoid ETFs/ETNs. Investing in good quality individual corporations are very good proxy for commodity asset class.