This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Nathan Faber, vice president of investment strategies at Boston-based Newfound Research LLC.
One key issue for investors with a low risk tolerance is inflation. There always comes a point where some risk must be taken to avoid the erosion of purchasing power.
Consider a retired couple who has amassed their target nest egg through prudent saving and disciplined investing. Assume that both partners are 62 years old. According to the IRS, the couple has a joint life expectancy of 29 years.
Unfortunately, inflation will progressively whittle away the value of their cash if they are earning no return. At 2% annual inflation, $1.00 today will only be worth $0.56 in 29 years, a loss in value of 44%.
If we assume the couple plans to spend all of their wealth in equal installments over the 29-year horizon, total purchasing power will take a 23% hit due to inflation.
If we plan more conservatively and use a 37-year horizon, which corresponds to the 95% confidence level of at least one surviving party, then the inflation toll gets even worse. At the same 2% inflation level, $1.00 today will be worth only $0.48 in 37 years. With the longer retirement horizon, total purchasing power is reduced by 28%.
Even if the investors factor this into their distribution calculations for determining their required initial nest egg, inflation is a volatile variable that could throw a wrench in those “no risk” plans. Doing nothing is a choice that still has risk.
Inflation Difficult To Predict
A problem with inflation in planning calculations is that it’s a tricky variable to predict. We can assume an average value, but actual inflation can vary considerably and can be elevated for extended periods.
Data from Federal Reserve Economic Data (FRED). Analysis by Newfound Research. Data from January 1947 to May 2016
The Federal Reserve publishes the quarterly forecasts of the Survey of Professional Forecasters, a group of economists that predict a number of macroeconomic variables. One of the variables they forecast is inflation.
We have shown before that even professional forecasters get things wrong. In fact, the Fed’s own error statistics show root-mean-square errors (essentially like a standard deviation) in the range of 1-2%, depending on how far into the future the forecast looks.
Assuming an expected value for inflation of 2% and normal distribution of inflation rates, we can say we are 95% confident that the inflation rate will fall between about -1% and 5%. That’s quite the spread!
What Investors Can Do
Since forecasting via surveys is an inherently human endeavor, maybe biases can be eliminated by relying on market efficiency.
By subtracting the yield on Treasury inflation-protected securities (TIPS) from the yield on U.S. Treasurys of equal maturity, we can calculate the market expectation for inflation.
Data from Federal Reserve Economic Data (FRED). Analysis by Newfound Research. Data from January 2003 to June 2016.
From this, we get inflation estimates that are based on everyone trading in the market. Surely that must be better than a group of professional forecasters.
However, the Fed’s own research has shown that market-based inflation forecasts are not much better than either the human survey respondent or just using a fixed value for the forecast (e.g., 2%). The graph below shows that while there may be a relationship between market-predicted and realized five-year inflation rates, it is complex and definitely not linear.
Data from Federal Reserve Economic Data (FRED). Analysis by Newfound Research. Data from January 2003 to May 2016.
How Does This Relate To ETFs?
Investors have access to TIPS through a variety of ETFs. The iShares TIPS Bond ETF (TIP | A-99) is by far the largest, with $18 billion in assets under management, but there are a handful of others with over $500 million, some of which cover a specific range of TIPS maturities, and others that invest in international TIPS.
But since 2013, this has not panned out too well for investors. Below, we compare the performance of TIP to a similar-duration investment in U.S. Treasurys. We use the iShares 7-10 Year Treasury ETF (IEF | A-55) as the proxy for U.S. Treasurys.
Data from Yahoo Finance. Data from December 2003 to June 2016.
Reversing Trend In TIPS
A static allocation to TIPS has not looked very good. But based on the break-even inflation rates and the current economic outlook, that trend may be poised to reverse.
Break-even inflation rates have come down below the Fed’s stated 2% inflation target. When this has happened in the past (2003 and 2008), the following five years have seen negative inflation surprises, which are when the realized inflation turns out to be higher than the predicted inflation at the beginning of the period.
Negative inflation surprises are positive for TIPS relative to nominal Treasurys.
Data from Yahoo Finance. Analysis by Newfound Research. Data from December 2003 to May 2016.
Since the research shows that neither expert forecasters nor the market are very good at predicting inflation, the playing field is leveled for investors.
As always, past performance is no guarantee of future results, but depending on your outlook on inflation, the lower break-even rate may indicate a good entry point into TIPS, especially if you had already been thinking of adding a static position to diversify core bond holdings, as many core aggregate bond ETFs exclude TIPS.
At the time of writing, Newfound Research held TIP and IEF among its universe of ETFs included in its Newfound Target Income Portfolios. Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.