Flawed Inflation-Hedging ETFs

October 03, 2011

The threat of global inflation has been one of the hot-button market topics for what seems like forever, and yet the options for hedging against it are still spotty at best.

Even the latest plans for four synthetic inflation ETFs from ProShares do little to improve upon the existing stable of inflation-linked ETFs.

Sure, the new portfolios will offer investors betting against inflation a way to play without getting their own derivatives exposure, but is a leveraged fund that rebalances daily really a breakthrough? After all, a massive TIPs fund already exists, the iShares Barclays TIPS Fund (NYSEArca: TIP), and it has the liquidity that these ProShares funds probably won’t be able to hold a candle to when they come to market.

Even TIP, for all its liquidity, is not without its warts. TIP owns only U.S. Treasury-issued inflation-protected securities, giving an investor zero protection from a declining dollar, which, let’s face it, is a symptom of inflation. Furthermore, the principal adjustment that gives TIPS their inflation protection is indexed to the CPI, an utterly flawed way of measuring true consumer inflation in this country.

Regardless of whether you believe inflation is a problem here in the U.S., the data show it’s already rearing its head in Europe, Asia and Latin America. The challenge for ETF investors is that none of the existing ETFs or any of those in registration provides an appropriate hedge.

Take the Index IQ Real Return (NYSEArca: CPI), with its clever ticker. The fund is perhaps the most creative portfolio of any of the so-called inflation busters, and yet it’s as flawed as a Zale’s diamond.

First and foremost, CPI is a fund of funds. This makes it inherently more expensive than a traditional ETF. Further, the fund holds more than 80 percent of its assets in traditional Treasury-bond and note funds, an asset class that’s likely to suffer, not benefit, in times of rising inflation.

Sure, it’s nice that the fund allocates to gold, but is owning yen, euros and British pounds a sound solution to domestic inflation if those economies are plagued by the same problems?

Unfortunately, WisdomTree’s Global Real Return ETF (NYSEArca: RRF) isn’t much better.

Despite the fact that the ETF’s underlying index tracks inflation-linked securities from countries around the world, its top 10 holdings include U.S. Treasury bonds and notes—again assets that don’t provide any protection from inflation and whose prices will fall in a period of rising inflation expectations.

RRF’s current portfolio is nearly 68 percent weighted to inflation-linked securities globally, but part of that exposure includes swaps. Why would an investor, looking to hedge inflation, pay 60 basis points a year to have swap exposure and commodities-futures exposure, in addition to the more sensible inflation-protected exposure and gold holdings?

After all, commodities may be a good inflation hedge historically, but do we really trust the manager of RRF to be able to mitigate the risks of contango and backwardation in 10 different commodities? I wonder.

From a cost perspective, why own an expensive fund like RRF when you can pay just 5 basis points more, in blended expense ratio, to own a 50-50 combination of the iShares Global Inflation-Linked Bond Fund (NYSEArca: GTIP) and the iShares Gold Trust (NYSEArca: IAU)?

As Warren Buffett said, “There seems to be some perverse human characteristic that likes to make easy things difficult . . . it’s likely to continue that way.”

For ETF providers, it seems creating simple inflation hedges has been trumped by a desire to stay ahead of the proverbial curve.

Hopefully, investors see the forest through the trees. There’s no sense in owning complex, derivative-based portfolios to profit from a strategy that can be achieved cheaply and simply by combining positions in IAU and GTIP.


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