Northern Trust’s FlexShares ETF arm offers 32 ETFs with a total of $23 billion in assets under management. Christopher Huemmer has been the issuer’s senior investment strategist for more than a decade, and he has some definite thoughts on where investors should turn in today’s rocky markets. ETF.com caught up with him at the Exchange conference in Miami Beach, Florida.
This interview has been edited for clarity and brevity.
ETF.com: Where should investors be looking in the current environment?
Christopher Huemmer: In an inflationary environment like we're in now—stock and bond prices are positively correlated, meaning that when rate hikes are happening, stock prices are falling—you tend to see what we're seeing now, which is the stock market is selling off and bond total returns are down.
Where do you go in this type of environment? Typically, it's alts, or real assets. So that's what we’re focused on. Real assets take the cake in those environments. Things like global natural resources, infrastructure, real estate, all of those tend to do well in an inflationary environment like we're in today.
ETF.com: How unusual is the current environment?
Huemmer: You have to go back [quite a while]. The CPI number that came out today [April 12] was based on March. If you look at shelter, which makes up 40% of the CPI calculation, it's based on two components: owner equivalent rent and rental of primary residences.
Both of those numbers over the last six months have gone up pretty significantly. Owner-equivalent rent is up 5.3% and RPR is up 5.59%. The last time we saw a print that high was August 1986. We’re at levels we haven’t seen in quite some time. And to be fair, we haven't really been in an inflationary environment in quite some time.
All of the models that are built around the 60/40 portfolio [are based on the idea that] when bonds aren’t doing well, stocks do well, or when stocks do well, bonds aren't doing well.
All those correlations break down in inflationary environments, and that's [why] real assets, which were a big thing back in the last inflationary environment, should be back in people's portfolios today, and it should be something they're looking at.
ETF.com: How do you define “real assets”? That can vary depending on perspective.
Huemmer: Commodities or natural resource equities both fit in the same bucket. I would also look at infrastructure and real estate as types of real assets.
[With commodities,] you're talking about more short-term holding periods, because the way you're getting your commodities exposure is using derivatives, typically futures contracts. That spot price, which is what you're trying to get, makes sense in the short term. But if you're looking at a more strategic holding, it's a little bit harder to do, because the roll yield comes into play.
Typically, with the commodities future curve, future commodity prices are higher than current prices, and that’s called contango. In that kind of environment, every time you roll your derivative contracts over, you're losing money. There's usually a breakeven calculation of how much do [for example] energy prices have to increase for you to break even. In that case, you're losing returns when you're rolling those contracts over.
If you're a tax-sensitive client, you're realizing that gain, and then you're paying taxes on it, whereas if you take a natural resource equity approach, especially if you're focusing on the upstream portion—which is what we do in the FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR)—what you find when you look at that is you get the same correlation to commodities over a five- or 10-year period.
But the benefit is you're holding the same securities. The efficiency of that as an investment vehicle is better than if you were looking at it from a contract over the long strategic window.
ETF.com: What about Treasury inflation-protected securities (TIPS)? The largest TIPS ETF has had outflows year-to-date, when it seems like a time people would want to buy into that asset class right now.
Huemmer: The way we look at inflation is a multitime horizon. We look at short term, intermediate term and long term. Intermediate term is where commodities and natural resources play. On the long term, that's where infrastructure or real estate comes in. And in the short end, that's where TIPS are.
TIPS are really good for unexpected inflation, as well as inflation over the short term. With a TIP security, over the long run, the correlation with CPI breaks down because the interest rate component of the TIP overwhelms the inflation component. Because of that, they work best in that short-term window.
There are periods where you want to be in TIPS. And I think that’s the case if you think inflation is going to come in higher than expectations. But the key thing with TIPS is being aware of the duration exposure of your TIPS.
As interest rates are being hiked, being in long duration TIPS might not be the best security. The longer your duration is, the more sensitive to interest rate hikes you are. Changes in interest rate hikes are a primary driver of that, so having a lower duration, or a targeted duration, makes a lot of sense.
That's why we designed our two TIPS products, the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT) and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF) [the way we did]. They take targeted duration approaches—one has a three-year duration, one takes a five-year duration. Typically, a market-weighted TIPS strategy has a duration of, say, seven [years], currently. From a TIPS standpoint, be aware of the duration exposure, as well as what's happening from an inflation standpoint.
ETF.com: What about international diversification in the current environment? Does it make sense? There's so much going on at the global level, with the winding down of the pandemic and the outbreak of the Russia-Ukraine war. And in recent years, I’ve heard that some investors are turning away from the concept.
Huemmer: We are big proponents of taking a global approach to portfolios. Obviously, your allocation to U.S. versus developed markets or emerging markets varies based on your risk standpoint, but you still get diversification benefits.
One of the great examples of that is real estate. When we talk to advisors, when they say they own real estate or REITS, they typically own U.S. REITs. We advocate for a global approach for three reasons.
One, U.S. real estate tends to be more volatile than developed ex-U.S. real estate. When we talk about global real estate, we're looking at U.S., developed ex-U.S. and developed Asia Pacific. Typically, you see that the ex-U.S. piece is less volatile than the U.S. piece, so blending it with U.S. gives you a less volatile ride in the real estate space.
Additionally, there's historically been such good diversification from including those areas—even in the global financial crisis, the correlations increased, but they didn't move to close to 1, which is what you saw from global equity markets. Having that global diversification makes a lot of sense in real estate.
Third, from an evaluation standpoint, international real estate is much more attractively priced than U.S. real estate. I wouldn't advocate for moving to international from U.S.; I think you want to take an approach that takes both U.S. and international together. I definitely advocate for a global approach to real estate.
ETF.com: What about fixed income in general, given that bonds are not doing what they've historically done? What do you do to counterbalance the fact that bonds are not providing what investors traditionally want them to provide to the portfolio?
Huemmer: I think that's a struggle today with interest rates going higher. One of the things that, as a firm, Northern Trust has looked at, is credit versus term risk. Term risk is your sensitivity to duration. Credit risk, in some cases right now, makes a lot of sense.
If you look at our asset allocation models, we're overweight high yield, in particular, because high yield has less term exposure and more credit exposure. And our view of corporate balance sheets is that corporations are better positioned than in other downturns. We have a conviction behind taking on credit risk instead of duration risk in the fixed income space.
ETF.com: What approach should investors be taking in equity markets?
Huemmer: We're seeing because of the rate hikes that there is a repositioning of equity portfolios happening, and you're seeing investors move more towards value—rightfully so. In rising rate environments, typically, you tend to see value do well, so it makes a lot of sense that value is outperforming and that we're seeing investors move that way.
The other area I think we'll see more investors move towards is low volatility. I think low volatility [makes sense] when you're looking at de-risking your portfolio over time, especially with fixed income being in a challenging position, with inflation at 8.5%.
Even if you're getting 2%off cash—which no one's getting today—that is, from a real return perspective, [you’re] still well underwater. Staying in equity markets but taking a low volatility approach might be a good way to de-risk your portfolio while still participating in the upside of equity markets.
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