Deflation is a real concern for any global economy, and the United States is far from immune from this potentially devastating reality. Still, even if you don’t want to make a huge bet on falling consumer prices, you still should consider diversifying your portfolio by investing in one or some of the best funds for deflation.
Here’s the deflationary concern: The most recent reading of the Consumer Price Index, the CPI Report for December 2014, showed that consumer prices fell 0.4%, the largest drop since 2008. Overall consumer prices grew 0.8% in 2014 — the second smallest calendar-year increase in the last 50 years.
Gas prices plummeted in 2014, which was a primary driver of the lower CPI readings. But to prove there is no real threat of a deflationary environment, consumers still need to show that they are spending their extra cash resulting from lower prices at the gas pump. Not to mention, if gas prices do rebound, we then get to worry about whether consumers will become more cautious in spending again.
There’s at least enough legitimate concern about potential deflation to justify a proactive investment to hedge your bets. So, let’s look at three of the best funds to invest for deflation:
Best Funds for Deflation: Vanguard 500 Index Fund (VFINX)
When deflation begins to rear its ugly head, investors need to think big, high quality and pricing power.
That makes the boring ol’ Vanguard 500 Index Fund (MUTF:VFINX) one of the best funds you could buy.
While you might have guessed that the first pick would’ve focused on larger value and ignored growth stocks, but there’s no need to concentrate that kind of bet — for these purposes, the blend of value and growth you get in the S&P 500 is a great idea.
The holdings for Vanguard 500 Index include big names that have shown resiliency and pricing power, like Apple Inc (NASDAQ:AAPL), along with the deep value names like Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B).
Passively managed index funds also remove what I call “manager risk,” which is the risk inherent with actively managed funds and the ever-present threat of making poor security selections, no matter the knowledge or skills.
VFINX has a cheap expense ratio of 0.17% and a minimum initial purchase of $3,000. Learn more about VFINX here.
Best Funds for Deflation: Pimco 25+ Year Zero Coupon US Treasury (ZROZ)
One of the best performing investments in deflation is zero-coupon bond funds, and Pimco 25+ Year Zero Coupon US Treasury (NYSEARCA:ZROZ) is the cream of the crop in that category.
The Federal Reserve will fight deflation by maintaining its low-interest-rate policy. This would have the effect of pushing bond yields lower, and because bond prices move in opposite direction as rates, bond prices would move higher.
Furthermore, long-term bond funds are more sensitive to rate changes, which means their prices will generally rise faster as interest rates are falling.
But the long-term bonds that are most sensitive to interest rates are zero-coupon bonds; therefore you’ll get the biggest gains in the low- and falling-interest-rate environments.
For example, in 2014, ZROZ had a whopping price gain of nearly 50%, and year-to-date, ZROZ still is up a decent 5%. If deflationary concerns linger on through 2015, you’ll see ZROZ continue to produce outsized gains.
Just be careful: That interest-rate sensitivity can work on the downside as well, especially if a surprise rate hike comes from the Fed.
ZROZ has a low expense ratio of 0.15%.
Best Funds for Deflation: SPDR Gold Trust (ETF) (GLD)
Although gold is traditionally viewed as a hedge against inflation, it can also be used as a hedge against an extreme deflationary environment and the best fund out there for investors in this case is SPDR Gold Trust (ETF) (NYSEARCA:GLD).
Conventional wisdom says to avoid gold during deflation because prices for commodities are generally falling. But when deflation hits hard, the uncertainty over asset prices and currencies will drive investors to build their gold positions. As the demand for gold increases, so does its price. Therefore, gold is ultimately a hedge against uncertainty.
For example, current sentiment toward the U.S. dollar is that it is strong compared to other currencies, which should weigh (and has weighed) on gold. Nonetheless, GLD is up 3.3% year-to-date. The last deflationary environment in the U.S. was 2008-09. GLD finished 5% higher in 2008 before spiking 24% in 2009.
GLD has a low expense ratio of 0.4%
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities.