Let History Help You Choose What’s Best

If we are entering a period of higher inflation, as some investors fear, what types of mutual funds offer the best bets?

Fund researcher CDA/Wiesenberger in Rockville, Md., recently examined that question with a look at the last big inflationary spurt, from 1977 to 1980. Over that four-year stretch, the consumer price index rose 10.3% annually, on average.

Although higher inflation is not a foregone conclusion, the first six months of 1996 have produced some signs that it might be on the rise, including climbing commodity prices and higher wages. Significantly, says CDA/Wiesenberger, the best performing fund categories in the first half of 1996 mirrored the leaders of the 1977-80 period, and the laggard lists also were similar.

Admittedly, the mutual fund arena was a much smaller place back then. All of the industry’s assets in 1977, a whopping $49 billion, could fit into the Fidelity Magellan Fund today. Still, the basic approaches to investing remain the same then and now, so the history lesson could prove insightful.

“When considering what types of funds to avoid during inflation, investors should take a clue from the past and stay out of income-dependent situations such as bond and utility funds,” CDA/Wiesenberger advises.

To nobody’s surprise, the best performing category in the Jimmy Carter era was gold mutual funds, which averaged gains of 58% a year over that stretch. Gold historically has been perceived as the ultimate store of value during times when paper currency is eroding.

Natural resource funds, which concentrate on oil stocks and the shares of other commodity-rich companies, also logged an impressive average gain of 26% a year.

“Generally, inflation is driven by a strong economy, and when the economy’s strong, demand for raw material products goes up,” says George Roche, manager of T. Rowe Price New Era, a natural resource fund in Baltimore.

Beyond these two specialized sectors, what’s interesting is how well diversified-stock funds fared. Aggressive-growth portfolios, which pursue maximum capital gains, averaged returns of 28% annually over the four-year stretch, just a step ahead of small stock funds.

Growth funds added 19% a year, and international stock funds added 17%. Even sluggish equity income portfolios advanced 10% a year, just keeping pace with inflation.

If inflation rattles consumers, drives up business costs and leads to higher interest rates, why did stock portfolios fare so well?

In short, vibrant companies seem able to pass price increases to their customers, minimizing the negative effect on bottom lines.

Meanwhile, dividend-paying companies often can boost the amount of income they pass on to investors, making their shares attractive compared with bonds, whose interest payments stay flat over the years.

“It gets back to the question of, ‘Where will you put your money?’ ” says Bob Gabele, principal analyst at CDA/Wiesenberger. “After the initial shock [from higher inflation], stocks don’t look so bad.”

That feeling is seconded by Dennis Miller of Miller-Russell Co., a Phoenix investment firm. “Inflation creates a push-pull problem for investors but I would still buy growth stocks [or funds] in an inflationary environment,” he says.

Bond funds do not fare nearly so well in inflationary periods, according to the study. They brought up the rear between 1977 and 1980, with performance ranging from paltry annual gains to outright losses in the case of municipal funds.

Besides being inflationary, the 1977-1980 period was marked by rapidly rising interest rates, as the Federal Reserve Board battled to cool the economy. Higher rates wreak havoc on bond prices because the two move inversely.

Gabele argues against holding more than a small stake in gold funds, as he’s not convinced that the metal remains the inflation hedge it once was. Miller also is cool on gold funds, partly because he considers them to be too speculative, and partly because he figures intense global competition will keep a lid on inflation.

Even Roche, who has leeway to put gold stocks in the New Era fund, is limiting these positions to just 15% or so.

“The preconditions for higher inflation are there,” he says, referring to rising commodity costs and nervousness over wages. “But every time it starts to heat up, the Federal Reserve lowers the boom.”