Q: Why do you think right now an investor should consider inflation at all?

A: When you look at Consumer Price Index (CPI) for example and you break it down into its two main components you get a very different picture of the two pieces. The first piece is the goods piece of CPI and that represents items as you might expect – hard goods, things like televisions, washers and dryers and things that you can touch and feel everyday, and that component of CPI has been going up very slowly. In fact there have been months that it’s actually been down. The year-over-year change on that piece of CPI is about 0.3%. That’s what has been keeping prices down and when you think about why that’s the case, there has been a lot of foreign competition for those items, there is assembly that is done abroad and cheap labor from abroad tends to keep prices low. The other factor is demand. Frequently, goods are discretionary so consumers can delay purchases, decreasing demand.

The other piece of CPI, which represents the remaining 60%, is the services component. Those are the intangibles in CPI, that you can’t touch and feel everyday, for example items like tuition costs, cable bills, haircuts, things like that, and those prices have been rising at 3.6% on a year-over-year basis. And those are items that people need everyday or every month and you can’t escape the price increases that people have been experiencing in that part of their lives. So, as a result of the rising costs of those items, people need to think about inflation.

Inflation on the whole will start to rise as the economy picks up because service inflation won’t go away, we believe it is going to stay at about this level and perhaps go slightly higher. It’s the goods component of CPI that we are convinced will start to rise as the economy starts to pick up and that will then flow through more directly in the CPI.

When you look at the impact of inflation, a lot of people have said why should I care about inflation being only 2% or maybe a little bit less. What they don’t realize is that 2% inflation over a 20-year investment horizon can have a material impact on someone’s portfolio. If you had a thousand dollars, that thousand dollars will only be able to buy $673 worth of goods 20 years later.

If you are living on fixed income, that fact will have a material impact on your standard of living. So you need to look to this asset class of protection because it is the only asset class that is guaranteed to protect your investment from inflation.

Q: What are inflation-protected bonds and how does that protection work, exactly?

A: The inflation-protected securities market here in the United States started in 1997 and since then the government has issued over $150 billion worth of treasuries with inflation protection. One of the reasons the government wanted to issue this type of security was because it gives the Treasury a direct read on what the market’s expecting for future inflation, so it’s a barometer for them for future inflation expectations.

Over time the government has issued about 4% of their debt outstanding in treasuries with inflation protection. That number fluctuates year-to-year depending on how much treasury debt they are issuing. Right now they’re moving from a three-times-a-year issuance cycle to a four-times-a-year issuance cycle. So there is definite support to continue this program. There are currently 11 issues outstanding. The shortest issue matures in 2007, and the longest issue matures in 2032 and they are now focusing on 10-year issuance. When you look at trading volume, it is somewhere between $2 and $5 billion everyday.
They adjust the principal value as a result of CPI and then the coupon that you receive on the securities gets paid on this higher principal value. For example, I am going to give you an annual period to make it easy, if you had 4% inflation over a year the government would add to your principal 4%. So, if you invested $1000, the government would add $40 to your principal value and you would receive that at maturity. And if you had a 3.5% coupon that was paid on these securities instead of getting $35 each year, you would get $36.40. Each coupon period you would get more coupon income. The coupon is adjusted not in its rate but in the fact that it is paying on a higher principal.

Q: So the coupon would be adjusted after the inflation has been announced for the subsequent period? There is no pre-adjustment?

A: No, the way it actually works is, for example, the CPI that was released on June 17, 2003 starts being added to these securities everyday on July 1, and that CPI number gets added on a daily basis over the course of the month.

Q: So there is a schedule?

A: Yes, you can go to a Treasury website and you can see the principal going up as CPI goes up.

Q: What are the ways you build a portfolio?

A: The investment process that we have here is based upon three components. One is fundamental analysis, the second is market pricing and the third is a bit of technical analysis. From a fundamental analysis perspective, what we do is bottom-up research. We start, however, with a broad view on the economy and market and we do that through an investment strategy process that we have here which incorporates all of the senior investment professionals. We meet once a month to come up with our outlook on where we think the economy is going and where we think different sectors of the economy are going. And from that we then talk about the various components of the fixed income market. We take that information and we then look at each of the individual sectors.

Let me give you an example. We develop an inflation outlook as a result of our strategy meetings and in today’s world our view is somewhere between 2% and 2.5% inflation over the next year.

So, today the inflation protected treasury market is pricing in about 1.7% inflation on average over the next 10 years. We believe that is too low because our view is higher than that. And in fact when you go back to put it into context when you look back over time, inflation hasn’t averaged 1.7% or lower since the early 1960s. So, we believe that the market is undervaluing future inflation, therefore we should own a lot of inflation protected securities in a portfolio because the inflation is cheap right now compared to what the market is pricing in the traditional treasury market.

Q: And the fund has been recently launched?

A: November 1, 2002.

Q: What percentage of total return is through active management?