Mark Dampier: Equity-income funds can stop inflation picking your pocket

Built to outpace inflation: bonds issued by Toyota Motor Corporation are among the investments in the M&G fund (AFP/Getty Images)

UK inflation figures make headlines in the financial press when they are released each month.

I wonder how many people really understand the effect it has on the pound in your pocket. From time to time it is worth reflecting on this and recapping what inflation actually is.

In some respects it is rather like being pickpocketed frequently over many years. For instance, goods and services costing £100 in 1993 would have cost £177.75 in 2013. In other words, prices rose at 2.9 per cent per year on average. This is why it is important for income, savings and investments to grow at least in line with inflation. Otherwise your money will buy fewer goods and services in future.

This is a point I often emphasise when reviewing equity-income funds, particularly with respect to dividends – these have the potential to increase ahead of inflation over the long term.

The actual rate of inflation many people experience will be higher than the official figures suggest. Official figures take into account many items which have come down in price, but which are discretionary purchases. These include items such as personal computers, cameras and other gadgets. Yet life essentials – food, power and water etc – are often increasing in price, meaning retired people on fixed pensions or dependent on income from their investment capital are the hardest hit.

I suggest UK and global equity-income funds are generally a good way to combat inflation over the longer term, though for some investors, having all their capital in the stock market is not prudent. Similarly, in an environment of ultra-low interest rates, returns on cash deposit have generally been below the rate of inflation; although it remains sensible to keep some funds in cash for a rainy day.

Traditional corporate bonds offer no shelter against rising inflation as the income they pay, and their capital, are fixed. However, there are bond portfolios available which aim to beat inflation.

The M&G UK Inflation Linked Corporate Bond Fund, managed by Ben Lord and Jim Leaviss, aims to provide a return above the rate of UK inflation over the longer term. It does this by investing partly in a portfolio of index-linked UK government and corporate bonds. In addition, the managers use derivatives to add an element of corporate-bond exposure alongside the index-linked government bonds, effectively giving the portfolio exposure to corporate bonds with some inflation protection built in. Derivatives are also used to reduce the sensitivity of the fund to rising inflation or interest rates.

The use of derivatives has shortened the fund's duration to 1.25 years, considerably reducing its overall sensitivity to interest rates. This is important – conventional UK index-linked gilts, and the few available index-linked corporate bonds, tend to have a relatively long life. At first glance you might view this as a positive. However, the longer until a bond's maturity, the greater its sensitivity to changes in interest rates.

As such, this fund could offer some protection relative to traditional corporate bonds if interest rates rise.

Given the fund's strategy, income-seekers should note it tends to pay out little in the way of income, which is partly eroded by the costs involved in its use of derivatives and shorting.

Inflation has fallen back recently, though the managers believe inflation expectations over the longer term are being underestimated. Vast sums of money have been supplied to banks through quantitative easing; if this is released into the economy through increased bank lending, inflation could rise quite fast. However, at present there is little sign of this and the latest Funding for Lending Scheme (FLS) figures do not show much appetite for borrowings (the Bank of England launched the FLS in 2012 to incentivise banks to boost their lending to the UK economy).

Since its launch in September 2010 the fund has maintained the purchasing power of investors' capital, growing by 15.8 per cent compared with a rise of 11.3 per cent for the consumer prices index – the Bank of England's preferred measure of inflation.

This is not the type of fund likely to give you significant gains, but I believe it could be considered by investors who wish to shelter the spending power of their capital against inflation and take a more-cautious approach. It could also be used to diversify and reduce the volatility of an existing portfolio of bonds or a more equity-focused portfolio.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.hl.co.uk