Using ETFs To Hedge Inflation Risk

November 22, 2021

For much of 2021, inflation has been the bogeyman in the shadows, lurking in the background and spooking some equity and bond ETFs throughout the year.

But October’s CPI reading is the latest sign that this threat to market stability is growing. Consumer prices jumped 6.2% from the year prior, hitting a three-decade high.

Inflation could be particularly disastrous to portfolios as it tightens the correlation between equity and fixed income assets closer together at exactly the wrong time.

While a moderate amount of inflation is potentially good for equities, surging costs can hurt a company’s profits. And rising rates can weigh particularly heavy on growth stocks, as these valuations tend to be sensitive to investors’ perception of future inflation.

While equity markets have so far shaken off inflation fears, continuing their ascent, the bond market has not been quite as lucky. Rising rates negatively impact bonds due to the inverse relationship between prices and yields.

Year-to-date, the iShares Core U.S. Aggregate Bond ETF (AGG) has fallen by 1.6% as the yield curve has steepened since the start of the year.

 

 

Investors Have Many Options

The good news is that ETF investors have options when it comes to allocating to areas of the market that hedge against inflation risk. Several of these “inflation hedge” assets have offered protection this year as the specter of inflation grows.

Inflation-linked bond ETFs, like the iShares Bond ETF (TIP) and the Schwab U.S. TIPS ETF (SCHP) have garnered significant investor attention this year. Both funds have drawn billions in net flows since Jan. 1.

 

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How TIPS Work

TIPS pay a fixed interest rate, but the principal value is adjusted up or down based on inflation as measured by the CPI. As CPI increases and the principal is adjusted higher, the coupon payment is higher due to the increased principal value.

Strong relative performance in this asset class is typically driven by a change in inflation expectations, rather than inflation overall.

Growing concern over inflation has allowed these ETFs to climb in an otherwise challenging environment for fixed income. Both TIP and SCHP are up over 6.0% for the year, far outpacing AGG’s 1.6% loss.

 

 

Another option that offers exposure to TIPS is the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL). This fund is actively managed, with a portfolio consisting of TIPS and long options tied to the U.S. interest rate swap curve.

IVOL outperformed TIP early in the year, though after a sharp decline in June, is now up only 1.6% YTD.

 

 

Mixed Results For Commodities

Research has shown commodities to be a powerful inflation hedge. Investors have both targeted and diversified options when it comes to adding commodity exposure to their portfolio.

The SPDR Gold Trust (GLD) tracks the spot price of gold, which is often hailed as a proven inflation hedge. That said, the precious metal has not held up so far this year, notching a 2.7% loss YTD.

 

 

Some have speculated that gold may have lost a bit of its shine as an inflation hedge due to the growing acceptance of bitcoin and other cryptocurrencies.

While bitcoin futures ETFs don’t have a long enough track record to assess their usefulness as an inflation hedge, the WisdomTree Enhanced Commodity Strategy Fund (GCC) became the first ETF to offer exposure to bitcoin futures, adding a 3% allocation in mid-October.

GCC actively manages its exposure to commodities and can hold up to a 5% allocation in bitcoin futures.

Passive Beats Active YTD

GCC’s broader, active take on the commodity space has outperformed GLD so far this year, but has underperformed the passive Invesco DB Commodity Index Tracking Fund (DBC), which uses futures contracts to track a diversified index of 14 commodities.

 

 

Natural Resource Equities Another Option

ETFs that focus on stocks related to natural resources are another option to hedge the risk of inflation.

Rather than using futures contracts, ETFs such as the FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR) offer exposure to companies involved in the production of energy, agriculture, metals, timber and water.

After rising in tandem with DBC through the first half of the year, GUNR’s performance diverged in the months after. The ETF is up 21.1% for the year, meaning DBC has gained nearly twice as much.

 

 

Similar to gold miners, stocks for companies involved in natural resource production will have a higher correlation to the equity market overall relative to commodity futures or spot prices. This could be cause for concern if inflation weighs equities down in the future.

But according to Chris Huemmer, senior investment strategist at FlexShares, his view that high levels of inflation will be transitory is what makes this type of exposure desirable, as it creates a more supportive environment for equities over TIPS.

 “Valuations on natural resource equities are still compelling, and it plays into our risk-on mindset. Generally speaking, we’re bullish on equity markets,” he said

Contact Jessica Ferringer at [email protected] or follow her on Twitter

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