How should investors spell inflation protection? C-O-M-M-O-D-I-T-I-E-S.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is co-authored by Rusty Vanneman, chief investment officer of Omaha, Neb.-based CLS Investments and Michael Ashton, managing principal, Enduring Investments.
The Consumer Price Index (CPI) rose in the most recent release to 2 percent on a year-over-year basis, and is near its highest level since early 2012.
More worrisome, the Cleveland Fed’s Median CPI, which measures the price change of the “median” category every month, jumped 0.3 percent in April—the largest move since 2008—and is at 2.2 percent on a year-over-year basis.
Nearly 70 percent of the categories in the CPI saw the annual rate of inflation increase from March to April, which represents a breadth of inflation acceleration about as bad as we have seen in at least 15 years.
In this context, it’s no surprise that some investors are growing increasingly concerned about the possibility that the extraordinarily loose monetary policy of the last six years could lead to greater inflation ahead.
So, how should investors scouring the ETF landscape where quite an array of options are available prepare?
We believe a broadly diversified portfolio of commodities may well be the best choice at this time, though inflation is complex and so too is inflation protection. That means that the appropriate choice today may not be the appropriate choice tomorrow.
With these complexities in mind, let’s survey what’s available right now.
Two Inflation-Protection Options
There are many asset classes that offer some sort of inflation protection.
After all, any asset class that doesn’t keep up with inflation in the long run is doomed to eventually fade to insignificance in the capital markets compared with those asset classes that, at least, keep pace with the price level.
However, many of these asset classes are difficult to access in a liquid form—think collectibles or farmland. Moreover, the sort of investment that represents solid protection when yields are high and already incorporate some expectations for higher inflation may not offer the same level of protection when yields are low. The same goes for other facets of the ever-changing market environment.
For the clearest example, take Treasury inflation-protected securities, otherwise known at TIPS.
Our favorite TIPS ETFs include:
- iShares TIPS Bond ETF (TIP | A-99)
- Pimco 1-5 Year U.S. TIPS ETF (STPZ | B-75)
- SPDR Barclays TIPS ETF (IPE | A-91)
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).
How To Choose
To review, it turns out that TIP represents good inflation protection coupled with good prospective performance when starting from higher yield levels. Conversely, USCI represents good inflation protection coupled with good prospective performance when starting from lower yield levels.
So, it stands to reason that investors would be best-served by strategically shifting allocations to these two ETFs as well as other ETFs that offer inflation protection from time to time as yields change.
Moreover, there are also other market conditions that we have also found that affect expected performance. What this means is that investors ought to be managing their allocations to inflation-protection assets on an ongoing basis, rather than simply buying a potpourri of asset classes when inflation fears appear.
However, we find that the opposite is usually true. Most investors have an idea of what sort of assets protect against inflation.
But ask the typical investor what’s driving those particular allocations, and how they expect to change the allocations as conditions change, and you’re unlikely to find a systematic approach. We believe there’s good value in simple, low-cost rebalancing rules based on a handful of powerful verities about how various asset classes interact when the inflation environment changes.
Presently, we believe the extremely low real-interest-rate environment argues for a significant weight in commodity indexes in the part of a portfolio designated for inflation protection. Other asset classes appear in that mix as well, but commodities are currently worth the lion’s share of it.
The question, of course, is how the mix should change over time. As interest rates rise, we’ll see TIPS offer better value relative to commodities, and our allocations will shift to that asset class.
And when interest rates rise sufficiently—that is when markets are discounting very high levels of future inflation, as they did in the early 1980s—then “traditional” asset classes such as bonds and equities will actually be priced to offer such generous inflation premiums. At that time, classic inflation-protecting assets will be much less important.
Getting to that point will not be enjoyable, but investors who use ETFs’ liquidity and flexibility to deploy such innovative tactical switching strategies stand a reasonable chance of surviving the journey in good shape.
CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected].
Rusty Vanneman joined CLS in September 2012 as chief investment officer. Michael Ashton is managing principal at Enduring Investments LLC, a consulting and investment-management firm offering focused inflation-market expertise. Mike and Rusty shared a cubicle at Thomson Financial’s Technical Data unit in the early 1990s.
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