Real Return ETF Hedges Against Inflation

ETF Trends

While inflation has been largely benign over the last several years it is unlikely to remain so forever, given the expansionary fiscal and monetary policies adopted by global central banks to combat the credit crisis that gripped the world’s economies in 2008.

As of this writing, 10-year treasuries were again approaching a yield of two percent, up from 1.5 percent just a few months ago.  In their daily lives, many investors have seen the prices for various goods and services continue to rise, providing anecdotal evidence that inflationary pressures continue to seep into the real world as well as the financial system.

In studying inflation over the last 100 years, we have seen that there is no single asset best suited to provide a hedge against inflation risk. Rather, we have found that a multi-asset approach is more likely to deliver the results desired by investors.

Are Traditional Investments Flawed?

There is a common perception that gold is a good hedge against inflation as it is a store of value and can retain its purchasing power in the event of rampant price increases.  This may have been true when currencies were actually backed by gold, but may be less true today.  Also, if everyone believes that gold is a good hedge, then its price will tend to rise as demand for gold rises with expected oncoming inflation.

We might also expect other commodities to be a hedge against inflation, since sometimes inflation is supply-side driven and as inputs to production rise, so do price levels.  The volatility of commodities as an asset class can be challenging, however, while the pricing of both oil and gold can be impacted by factors other than inflation (industrial demand, for example).

Short-term government bonds or short-term bank deposits might also serve as a good hedge. The argument is that this cash is given a fixed interest rate for a short period of time. The interest rate will have expected inflation built into it. To the extent that there is unexpected inflation, the rates will adjust for the next period of investment and since each period of investment is so small, the investor has a better chance of keeping up with both expected and unexpected inflation, though with a delay. [ETF Chart of the Day: Inflation Protection]

Treasury Inflation Protected Securities (TIPS) are thought to be good investments against inflation.  The underlying bonds promise a real return to investors.  Thus, if inflation is higher than expected, the bonds adjust their interest payments to keep the investor’s real return at the expected level. There are issues with TIPS, however, including the timing of interest payments and the fact that both principal and interest are subject to federal taxation in the year in which they are generated.  Again, TIPS as a stand-alone inflation hedge would appear to be flawed.

The stock market measures the discounted present value of dividends and earnings. To the extent that inflation pushes all prices up, one might expect that the future dividends will be bid up as well as future profits in nominal terms and hence prices will keep pace with inflation. Naturally, there are certain types of inflation that may hinder the functioning of the economy and/or cause firms to reduce their margins, which then might offset this. Additionally, certain sectors of the economy might do better depending on certain types of inflation, with equity prices suffering a similar divergence (i.e. consumer staples might outperform basic materials, or vice versa).

Real estate has always been thought of as a good hedge for inflation, because as prices of goods in the economy rise, so might the prices of relatively scarce resources such as land. Thus, one would think real estate would make a good inflation hedge.  But real estate returns can be fickle, as the last few years have so painfully demonstrated.

Finally, foreign exchange might be a particularly good hedge in a period of hyperinflation. A country that is experiencing hyperinflation will find it difficult to find many asset classes that keep up with it. In periods of hyperinflation the exchange rate is either depreciating fast or devalued in large lumps very frequently. In fact, one of the best decisions might be to hold one’s money in a stable, safe currency. This is equivalent to shorting one’s own currency.

Clearly each of these asset classes has some merit as an inflation hedge, but none is ideal on a standalone basis.  In fact, these asset classes react very differently in different inflationary environments.  Gold is important in providing a real return while considering the downside with respect to real versus expected inflation.  Oil also should play a small role in a given portfolio.  Inflation-protected bonds may be good instruments for hedging inflation when owned in isolation, but they have higher volatility than a portfolio of other inflation-sensitive assets and seem to be less important when combined with a group of other asset classes. [ETF Spotlight: Inflation Protection]

Therefore, if the goal is to create a portfolio that targets a real return across various inflationary environments, then a new, multi-asset approach is clearly needed.   Based on our work, which informed our thinking behind the IQ Real Return ETF (CPI), we have found that the best inflation-fighting strategy combines a core of short-term treasury securities with satellite positions in up to 11 additional asset classes, each with different sensitivities to the then current drivers of real inflation.  Our CPI ETF targets a real return of 2-3% over the Consumer Price Index, over the business cycle, with a volatility of approximately 2%.  We believe this modern approach to hedging your portfolio from the ravages of inflation is the most effective way to accomplish this in today’s complex and volatile global economy.

Adam Patti is the chief executive of IndexIQ.

This article is for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. There is no guarantee that the information supplied is accurate, complete, or timely, nor does it make any warranties with regards to the results obtained from its use. It is not intended to indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are inherent risks that individuals would need to consider.  The opinions are those of the authors as of February 15, 2013 and are subject to change at any time due to changes in market or economic conditions.

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