A Fund That Beats Inflation

If there was ever a time for Americans to pay attention to the purchasing power of their savings, it is now. The U.S. financial system appears to be on the verge of collapse, the federal rescue of banks and housing will expand an already yawning budget deficit, and the Federal Reserve is trying to energize the economy. No wonder the dollar has sunk and oil and gold prices have surged in recent days.

Pimco All Asset fund is more or less engineered for such times. Manager Rob Arnott says this fund of funds (all holdings are funds from the Pimco family) has three mandates.

The first is to increase the real purchasing power of investors over time, a fancy way of saying that the value of savings should stay ahead of the bite of inflation. A second, related objective is to provide investors with diversification beyond stocks and bonds, neither of which fares too well during periods of inflation. "Most investors don't have any meaningful investment in assets that do well in a reflationary world and inflationary climate," says Arnott.

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The third goal is to provide investors with the portfolio benefits of diversification by investing in assets relatively uncorrelated with U.S. stocks and bonds. Arnott, who is chairman of a firm called Research Affiliates and a quantitative analyst by background, notes that returns of a portfolio that consists of 60% stocks and 40% bonds correlate a surprisingly high 98% with U.S. stock-market returns.

As of June 30, nearly two-fifths of the fund's assets were in inflation-fighting investments, such as Treasury inflation-protected securities (TIPS) and commodities. Arnott has expected the economy to weaken for some time, but he says the link between the health of the economy and inflation is less powerful than what is generally believed.

Based on Arnott's research of historical data, the four best predictors of the inflation rate over the upcoming five years are (in order of importance) the real federal funds rate (the rate that banks charge each other for overnight loans -- a figure set by the Federal Reserve -- minus the inflation rate), the slope of the yield curve, the magnitude of the current account deficit and the size of budget deficits. Currently, the fed funds rate is two percentage points below the rate of inflation, the yield curve is fairly steep (meaning there's a significant gap between short-term and long-term interest rates) and the budget deficit is huge and rapidly expanding. All of this, Arnott says, points to escalating inflation ahead.

Arnott also has nearly two-fifths of the fund in "alternative strategies," the bulk of them emerging-markets currencies and bond funds from the Pimco family. Most of this money is in emerging-markets currencies. According to Arnott's analysis, the dollar is inexpensive compared with the euro but expensive compared with emerging-markets currencies. He notes that unlike the U.S., many emerging nations have current-account and fiscal surpluses and sound banking systems, along with abundant foreign reserves. "By classic measures of creditworthiness, they are more creditworthy than the U.S. Treasury," he says.

Intriguingly, Arnott is starting to grow more interested in the U.S. stock market and, particularly, the financial sector. He expects consumer spending to contract over the next three to six months and finds nonfinancial stocks relatively overvalued. "Two years from now we'll have a financial-services industry, and it will be much stronger," he says. "Fewer competitors will mean more pricing power for survivors."

The stated long-term goal of All Asset is to beat consumer price inflation by an average of five percentage points a year. Over the past five years, it hasn't quite met its objective. Over that period through September 22, the fund's Class D shares (symbol PASDX) returned 6.5% annualized. Consumer inflation has run at an annualized rate of 3.5% over the same period. Year-to-date, the Class D shares, which are available without sales charges through many discount brokers, lost 4.2%, beating Standard & Poor's 500-stock index by 12 percentage points.

One strike against the fund is its fairly stiff annual expense ratio of 1.56%, a figure that includes the fees of the underlying Pimco funds. If you invest through a broker that aggregates funds, you may be able to gain access to the fund's institutional class (PAAIX), which sports an annual expense ratio of 0.96%, with a relatively low minimum investment. Vanguard Brokerage Services, for instance, requires a $25,000 initial minimum for the institutional class.