Investing for inflation – Equity funds

I was recently asked by a national newspaper for equity fund suggestions that may benefit from rising inflation. In March 2021 I wrote a research piece that looked at funds for the reflation trade. In that article, I defined reflation as an environment of rapidly rising bond yields, when economic growth expectations are positive. Essentially reflation is where an economy and prices recover to a previous level. Obviously, in 2021 that previous reference point was the pre-pandemic economy.

Difference between inflation and reflation

So could I not just use the reflation piece of research to answer the question? To a certain extent, the answer is yes because there are similarities between early 2021 and now. However, there are also key differences between early 2021 and the inflationary environment of 2022. For example, in March 2021 we had the fear of rising inflation but the actual rate of inflation was still well below central bank targets, especially in the UK. However, in 2022 we are now living the reality of multi-decade high inflation rates, caused by a surge in energy and commodity prices, partly a result of the post-pandemic economic recovery but mainly as a result of the war in Ukraine. It means that the current inflationary environment is one where inflation is rising above the long-term trend, not returning to it. While last year's research piece gave an insight into what funds might benefit from a reflationary environment, it doesn't answer the wider question about inflationary periods in general. After all, it can be argued that reflation is just a subset (a type) of inflation. So what about inflationary periods not accompanied by strong economic tailwinds (like 2021 had) or periods where monetary policy is tighter and interest rates higher? Which equity funds are likely to perform better than their peers in a high and rising inflationary environment?

Best equity sectors for inflation

One way to tackle this broader question is to consider the types of companies that benefit from high and rising inflationary environments. In 2021 Schroders produced the following chart which summarises how different equity sectors performed in high and rising inflation environments between 1973 and 2020.

 

The y-axis shows the average 12-month inflation-adjusted return while the x-axis shows the chance that the sector produced a positive return over rolling 12-month periods based over the historical time period. The upshot is that sectors that inhabit the top-right quadrant are the inflation winners more often than not. They usually benefit from rising prices (such as energy) or can pass on rising costs to their customers (such as Health Care and Consumer Staples) so maintaining their profit margins. After all, consumers buy medicines when they are sick and so their motivations are less sensitive to price rises. The research was carried out on US equities but the findings can be transferred to other equity markets. You can see that generally, the wider stock market (labelled "US Equity Market") tended to produce a negative return when inflation was high and rising. This goes against conventional wisdom. The research shows that having exposure to key sectors will likely increase the performance of your portfolio.

The key inflation sectors are:

• Energy
• Consumer Staples
• Utilities
• Health Care
• Equity REITs

Now with the exception of Equity REITs (where funds that invest in them inhabit the "Property Other" unit trust sector) there are no funds sectors based upon sector exposure. All North American equity funds are just lumped together, for example, in the North America equity sector irrespective of how they invest. The problem for investors looking at funds is that it's not easy to tell which sectors funds invest in and therefore which have significant exposure to the aforementioned sectors.

Funds for inflation

Unit trusts

To identify a shortlist of possible equity funds that may outperform in an inflationary environment I first analysed over 2000 unit trusts to determine the sectors that they have exposure to. I then determined those funds that had a total of 30% or more of their assets exposed to the sectors listed below.

• Energy
• Consumer Staples
• Utilities
• Health Care
• Industrials

You will notice that I have removed Equity REITs, as funds that invest in Equity REITS can easily be found in the "Property Other" sector. But I have also added the Industrials sector as according to Schroders' research it statistically produces a positive return over a 12-month rolling period more frequently than the Utilities and Health Care sectors, while its average return is close to zero. The more sectors included in the screening process the more refined and useful the shortlist becomes. Of course just because a fund has exposure to these sectors doesn't ensure that that exposure is positive in the current environment. For example, you don't really want to invest in a fund right now that has lots of energy stocks if they are all based in Russia. So I only included those funds that have had a positive 3-month return, in order to avoid those funds that have been exposed to companies impacted negatively by the war in Ukraine.

The final shortlist of funds is produced below (click on the image to download the full pdf). I have highlighted the 3-month performance figures with the top performers in green and the weaker performers in red. But to be clear, all of the funds have outperformed their respective sector averages. For reference, the funds are members of the following sectors and I have listed the sector average 3-month return next to each sector below:

• Global (-6.27%)
• Latin America (+20.14%)
• North America (-4.76%)
• UK All Companies (-4.06%)
• UK Equity Income (+0.21%)

I have also coloured (in green) the names of those funds that also appeared in my funds for the reflation trade. What is great to see is that almost half of the top 20 funds below were highlighted as funds by me a year ago that can benefit from reflation (which is a form of inflation). This further validates my previous research. It's also interesting to note that the 2nd and 3rd funds on the list below (Fidelity American Special Situations and Invesco UK Opportunities) are both in my £50k portfolio which has been faring well, as well as being regulars in the BOTB. One thing you will notice is that Latin America has benefited from the boom in commodity prices - something that is at the heart of the latest inflation spike - and has been another BOTB constituent of late.

 

Investment trusts

Interestingly if you carry out the same exercise on investment trusts you only end up with a handful of potential funds to explore further and these are listed below:

Fund	Citi Code	% Industrials	% Health Care	% Energy	% Consumer Staples	% Utilities	3 month Performance %
Aberdeen Standard Fund Managers Ltd - Shires Income plc	GC11	8.04	4.86	10.12	8.73	4.96	0.81
Aberdeen Standard Fund Managers Ltd - The North American Income Trust plc	EB14	8.1	16	9.4	5.8	2.5	1.24
Allianz - Merchants Trust PLC	BJ25	12.8	6.1	7.5	14.6	9.1	1.91
BlackRock Investment Management (UK) Ltd - BlackRock Latin American IT	FJ26	8.9	6.1	7.6	10.2	1.5	27.63
BlackRock Investment Management (UK) Ltd - BlackRock Sustainable American Income Trust	GWOO	5.3	17.2	6	4.6	5.7	6.19
Janus Henderson - Henderson International Income Trust plc	N7O0	8.8	13.55	3.89	9.12	2.7	2.1
Janus Henderson - The City of London Investment Trust	HJ01	10.95	8.7	7.38	21.88	7.58	4.77
Scottish Investment Trust - The Scottish Investment Trust PLC	IM53	7	8	15	7	2	9.73

 

Unsurprisingly Janus Henderson - The City of London Investment Trust is listed. I say unsurprisingly because the fund has managed to raise its dividend every year for the last 50 years and as such provides an "inflation-proof" income stream as identified in our investment trust income heatmap.