Vanneman: An Inflation-Protection Primer

June 12, 2014

TIPS are U.S. government bonds whose coupons and principal are directly linked to the CPI. When you buy a TIPS bond, your after-inflation yield will be the yield-to-maturity of the bond when you bought it, if you hold it to maturity. That also assumes that your inflation resembles inflation for the average consumer.

However, like any fixed-rate bond, a TIPS bond’s price will fall when yields rise, and, if inflation increases, yields will surely rise as well. This means that TIPS are much better inflation-protecting instruments if purchased when their yields are high than when their yields are low.

On the other hand, commodity indexes tend to respond most aggressively to inflation when it first arrives. Note that this tends to be when interest rates—and especially real interest rates—are low.

By the time inflation expectations are firmly priced into the values of capital market instruments, however, commodities prices have generally already risen and are less certain to be good inflation protection at that time.

Note that we’re talking about broad-based commodity indexes rather than individual commodities like gold or copper. Unlike with individual commodities, an index presents other potential sources of return, such as the rebalancing effect.

These days, there are many broad-based commodity index ETFs, but our favorite at this time is for the USCI United States Commodity Index ETF (USCI | B-11) that uses an index from SummerHaven Investment Management.

USCI is interesting because it takes advantage of the observation that in the returns of a commodity futures strategy, it matters quite a bit whether the future’s curve is in “backwardation” (meaning that forward months trade at a lower price than the spot month) or “contango” (which means that the forward months trade at a higher price).

In a contango market, when the investor who is long the spot contract needs to roll to the next contract, he is selling the lower-priced contract and buying the higher-priced contract.

As an aside, this is the reason the United States Oil Fund (USO | A-100), which owns front-month Nymex crude oil contracts and rolls monthly, has underperformed spot crude oil dramatically since inception in April 2006.

From that time through the end of April this year, spot oil is up 45 percent and USO has fallen 46 percent. That’s nearly 100 percentage points of return that separates the two.

To return to broad commodity funds, a normal commodity index owns a broad group of commodities. It owns the ones in contango and the ones in backwardation.

But USCI, the one we currently favor, only owns 14 of the 27 eligible commodities at any one time. It selects the commodities it is invested in monthly based on the degree of contango or backwardation and on market momentum.

We think this fund is likely to outperform the broader ETFs and ETNs such as the iPath Dow Jones-UBS Commodity Index Total Return (DJP | A-18) and the iShares S&P GSCI Commodity-Index Trust (GSG | A-91).

 

Find your next ETF

Reset All