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 by Larry Whistler, president and chief investment officer of Buffalo, New York-based Nottingham Advisors.
As a general rule of thumb, the best time to buy insurance is typically before one actually needs it. Not only is it usually cheaper, it will be in place when something unanticipated occurs. The same is true regarding inflation protection.
While inflation hasn’t been something investors have had to worry about for quite some time, the huge central bank money printing experiment of the past seven years will likely instill some investors with anxiety about where interest rates can go from here.
Inflation protection strategies haven’t been gaining too much traction of late; however, we feel now might be a good time to consider them.
The long, slow decline in the level of inflation, and hence interest rates, over the past 30 years means few investors remember what a meaningful rise in the general price level can do to fixed-income portfolios. Only a handful of years over the past three decades have seen a backup in interest rates. Here in the U.S., the Federal Reserve hasn’t raised the federal funds rate in nearly 10 years. Moreover, policymakers today seem to profess greater concern over deflation rather than inflation.
All that said, it may not be a bad time to explore inflation-hedging strategies, especially for those investors with large fixed-income exposures.
A Multi-Asset Class Approach
At Nottingham Advisors, our Real Return Strategy was designed to offer a hedge for just such investors. The portfolio provides exposures to four distinct asset classes, all of which have demonstrated some inflation-fighting characteristics in the past.
The Real Return Strategy, as the graphic above makes clear, is a portfolio that maintains equal exposure to equities, commodities, fixed income and alternatives.
The reason for a multi-asset class approach is that inflation can be experienced in a variety of ways. The most well-known is the general rise in prices as measured by the consumer price index (CPI)—too many dollars chasing too few goods. There also exists commodity-driven inflation, which can be more transitory, yet still impact everyday consumers. Finally, asset price inflation has been the byproduct of quantitative easing here in the U.S., impacting the prices of investments such as equities, bonds and real estate.
To develop the history of price pressure more carefully, the chart below highlights six distinct periods of rising inflation.
Examining these periods, a quick analysis of the performance across several major asset classes reveals an important point. During each individual bout of inflation, performance varied across asset class. While commodities did well in some periods, stocks did better in others, and vice versa. This is largely a function of the various drivers behind each period’s uptick in inflation.
The implication here is significant; it calls for a more diversified approach to inflation protection. After all, it would be quite unfortunate for an investor to add protection to their portfolio only to have their hedge flounder because they took a singular view and simply chose incorrectly.
Inflation Protection Via ETFs
Within each asset class, our Real Return Strategy selects ETFs based upon their historical ability to keep pace during differing periods of inflation. The asset classes are rebalanced every three months to maintain equal exposures.
The largest holding in the equity portion of the portfolio is the Vanguard Dividend Appreciation ETF (VIG | A-77), which offers exposure to high-quality U.S. companies with a long history of raising dividends. Accompanying that is exposure to the broader U.S. market by way of the iShares S&P 500 Index ETF (IVV | A-99) and the PowerShares QQQ Trust Series ETF (QQQ | A-63).
Equities, in general, have been among the best long-term hedges against inflation. Finally, we add exposure to the infrastructure space via the SPDR Global Infrastructure ETF (GII | C-70). The infrastructure space can generally be characterized as consisting of firms with strong, stable cash flows and high pricing power.
In the commodities space, we divide our exposures between physical commodities—gold and silver—and companies engaged in the commodity space; namely, agribusiness and energy. For gold and silver exposure, we look to the precious metals ETFs, the SPDR Gold Shares (GLD | A-100) and the iShares Silver Trust (SLV | A-99). Both offer inexpensive, liquid exposure to physical commodities.
Paired with that is exposure to companies in the agribusiness and energy space by way of the Market Vectors Agribusiness ETF (MOO | C-91) and the Energy Select Sector SPDR Fund (XLE | A-98). Natural supply constraints in both sectors tend to drive prices higher during periods of increased demand.
Despite the pernicious effects of inflation on fixed-income holdings, our Real Return Strategy maintains a 25 percent allocation to the bond market. The exposures, however, include inflation-linked bonds such as those found in Treasury Inflation-Protected Securities (TIPS).
Nottingham uses both the iShares 0-5 Year TIPS Bond ETF (STIP | A-99) as well as the iShares TIPS Bond ETF (TIP | A-99) to hedge against domestic inflation, while holding the SPDR DB International Government Inflation-Protected Bond ETF (WIP | C), to guard against broader global inflation, mainly in the eurozone.
Short-term adjustable rate bonds are also held via the iShares Floating Rate Bond ETF (FLOT | 77), the PowerShares Senior Loan ETF (BKLN | C) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN | C). All of the above should outperform traditional fixed-rate bonds in an inflationary environment.
The final asset class is loosely defined as “alternatives.” In this category, we include exposures to real estate investment trusts as well as the currencies of commodity-based economies, such as those of Australia and Canada. We currently have exposure to the Vanguard REIT ETF (VNQ | A-89) and the Vanguard Global ex-US Real Estate ETF (VNQI | B-81). Although REITs tend to trade in sympathy with more traditional fixed-rate securities, the ability of property owners to raise rents over time helps make the REIT sector a decent long-term hedge against inflation.
For currency exposures, we use the CurrencyShares Australian Dollar ETF (FXA | B-100) and the CurrencyShares Canadian Dollar ETF (FXC | B-98). Both have annual expense ratios of 0.40 percent per year, or $40 for each $10,000 invested, and have enough liquidity to accommodate sizable positions.
Better To Be Early And Prepared ...
With the latest CPI for February showing no change in prices over the preceding 12 months, it would be hard to blame investors for ignoring inflation.
Having invested through multiple periods of rising interest rates throughout our history, however, we think it’s crucial to have some inflation-hedging strategy to consider. With the size of the Fed’s balance sheet having quintupled over the past six years, and with the odds for a late 2015 “lift-off” rising, now might prove to be a shrewd time to consider protecting fixed-income investments.
Exchange-traded funds can offer investors numerous ways to guard against rising prices. As always, it’s important to select low-cost, transparent and liquid ETFs when putting a portfolio together. A diversified mix of liquid, low-cost, transparent ETFs, thoughtfully constructed and periodically rebalanced, should help investors guard against the deleterious effects of inflation when it finally arrives.
Again, in our opinion, it’s better to be early and prepared than late and regretful.
At the time this article was written, the author’s firm owned shares in client portfolios of all the ETFs mentioned.
Nottingham Advisors is an ETF strategist that manages and advises on more than $1 billion in assets for advisors, institutions and individuals. Nottingham has been using ETFs since 2001 and currently offers five unique strategies with focuses on risk-based total return, current income and real return. To learn more, visit www.nottinghamadvisors.com or contact Nottingham directly at 716-633-3800. For all relevant disclosures, please go here.