Future Handbook on ETFs for Shielding Against Inflation
Inflation worries are escalating once more. The Federal Reserve's recent Economic Projections Summary indicates that central bank officials envision inflation possibly ending in 2025 at 2.5%, surpassing their earlier forecast of 2.1% and surpassing their 2% objective. There's a growing probability of a revival in consumer prices, and investors ought to ponder incorporating inflation protection into their portfolios.
The labor market is robust, economic growth is outperforming projections, and potential inflation-stimulating modifications in fiscal and immigration policies are under consideration. The bond market has already come to terms with the possibility that the Fed may no longer adjust monetary policy. The price of 10-year Treasury bonds has escalated by 0.90% over the past three months due to the improved economic climate.
There are several methods of wagering on the return of inflation using ETFs. The Fed's response to the menace of rising CPI, whether bond investors view inflation as temporary or enduring, and whether inflation is a global or U.S.-centric matter will shape the performance of various options.
Here are a few strategies to consider.
Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
VTIP concentrates on short-term Treasury Inflation-Protected Securities (TIPS) with maturities less than five years, thereby offering exposure to inflation-linked bonds with diminished interest rate risk. With a management fee of just 0.04%, it is one of the least expensive methods to obtain TIPS.
Like Treasuries, TIPS are backed by the complete faith and credit of the U.S. government. The most significant disparity is the coupon payments. TIPS coupons pay a fixed rate lower than Treasuries, but the principal, or the amount paid to the investor at maturity, increases based on the degree of inflation. Due to the fixed coupon component, TIPS are still affected by rising interest rates and can decrease in value if yields rise alongside inflation.
VTIP would be an adequate substitute to a comprehensive fixed-income ETF like AGG, which holds a mix of Treasuries, Agency MBS, and investment-grade corporate bonds. First, VTIP's duration is significantly shorter because it only holds bonds with less than five years to maturity. The 2.4-year duration makes VTIP less susceptible to a jump in interest rates. Second, the inflation component of the TIPS in VTIP should provide additional return if CPI increases more than currently expected by the bond market.
Go ahead and consider VTIP as a superior ETF to hold throughout rising inflation, not as a standalone investment that will provide a substantial positive return.
Simplify Interest Rate Hedge ETF (PFIX)
PFIX uses long-term interest rate options to profit from rising rates. It does not directly benefit from rising inflation. Instead, it focuses on increases in the 20-year interest rate through derivatives. The ETF obtains its exposure to higher rates by purchasing 7-year options on the 20-year swap rate.
When inflation rises, the Fed typically responds by raising the overnight rate. For instance, starting in 2022, the Fed increased the policy rate from 0.25% to 5.5% over a fifteen-month period as inflation surged beyond 9%. Thirty-year bond yields rose approximately 3% from the beginning of 2022 to the fall of 2023, aiding PFIX in generating a stellar 288% return during that time period.
Due to its use of options, PFIX offers amplified upside potential when rates and volatility increase. However, the ETF is vulnerable to considerable capital loss if interest rates fall and implied volatility decelerates. With an expense ratio of 0.50%, retail investors receive an institutional-grade strategy at a reasonable cost.
It is worth noting again that PFIX does not provide direct exposure to inflation. There is a possible scenario where inflation rises, and long-term interest rates decline. If the Fed acts early and forcefully by tightening rates once more, short-term yields may rise, but long-term yields may not do so or even fall.
PFIX will not deliver if inflation escalates without a corresponding rise in interest rates. PFIX performs best when the bond market is taken aback by higher-than-anticipated inflation and when the central bank is expected to react slowly to combat prices. The initial point of interest rates and volatility matters. The finest time to buy PFIX is when both yields and option volatility yields are low. Since bond yields have already begun to factor in higher inflation, rates would have to keep progressing higher for PFIX to build on its 10.5% gain in 2024.
In summary, PFIX would be an appropriate ETF if long-term rates and volatility surge rapidly, whether that surge comes from inflation or another factor, such as investor concern over budget deficits and diminished demand for long-term Treasuries.
ProShares Inflation Expectations ETF (RINF)
RINF profits from the widening difference between nominal Treasury and TIPS yields, known as the break-even inflation rate. For example, if a 30-year Treasury bond has a yield of 5% and a 30-year TIPS bond has a yield of 3%, the break-even inflation rate is 2%, indicating that investors expect inflation to average 2% annually over the next decade.
RINF targets inflation expectations directly, making it an effective early hedge before inflation materializes. The ETF deploys a straightforward strategy that combines long 30-year TIPS exposure with a short nominal Treasury position.
Performance is contingent on changes in market inflation expectations, not actual inflation. The current 30-year break-even inflation rate is 2.29%. If investors reprice inflation expectations higher, RINF will generate positive returns. For instance, inflation expectations have climbed approximately 0.24% since early September, and RINF has gained 5.1%.
Unlike the VTIP, RINF isn't directly influenced by interest rates, making it a pure play on inflation. It's a suitable option for investors keen on betting on anticipated higher inflation rates instead of increasing interest rates. However, if long-term Treasury term premiums surge without a corresponding uptick in inflation expectations, RINF might underperform.
The fund's modest 0.30% management fee makes it an attractive choice for capitalizing on rising inflation expectations.
VanEck Inflation Opportunities ETF (RAAX)
The bond market isn't the sole means of preparing for rising inflation. Various other asset classes have exhibited a positive correlation with ascending CPI. Investors can construct a mix of these assets, anticipating that past correlations will endure and that they'll climb alongside inflation.
For instance, RAAX is an ETF that adopts a diversified, actively managed approach, investing in assets across commodities, natural resources, equities, real estate, and infrastructure—sectors that have traditionally flourished in periods of rising inflation. Gold is its primary holding, accounting for 23% of its assets.
The flexible asset allocation adapts to evolving inflation trends and economic circumstances, and the exposure to commodities offers immediate protection against rising input costs that can fuel inflation. The strategy necessitates a longer investment horizon due to the imperfect short-term correlation between inflation and commodities, real estate, and other equities.
Real estate, for example, often thrives under inflationary conditions but can falter when interest rates or debt costs surge significantly. Additionally, commodities typically perform better when global demand increases rather than merely domestic demand in the U.S. At present, China, accountable for approximately 50% of global commodity demand, is experiencing deflation—not inflation—and bond yields are at record lows. China's economic downturn is impacting demand for copper, steel, oil, and other industrial inputs. A significant 23% of the fund's assets are directly invested in commodities, which will influence RAAX's performance.
RAAX tends to perform better when inflationary pressures are global, not solely U.S.-centric. Energy stocks, for example, may struggle if global demand softens at the same time as U.S. supply possibly expands under more lenient regulations in the new Trump administration.
RAAX would be an appropriate choice for investors aiming to modify their equity portfolio in favor of asset classes with a track record of surpassing the broader market during periods of global inflation. In 2022, the ETF returned a net 1.53% after deducting its 0.77% expense ratio, whereas the S&P 500 lost 18.1%.
Selecting the Right Inflation ETF
Investors can equip their portfolios for a shift in realized or anticipated inflation in several ways. While VTIP might outperform the broader bond market, it's unlikely to deliver significant positive returns. PFIX is a suitable selection for investors betting on escalating long-term interest rates as an indirect consequence of inflation. RINF provides direct exposure to surging break-even inflation levels. RAAX enables investors to invest in sectors and asset classes that have historically excelled in inflationary periods.
Before selecting an inflation-friendly ETF, investors have numerous considerations to address. How will the Fed and the market react to increasing price levels? Will the Fed act promptly or consider inflation transitory? How much inflation is already factored into the market? Will assets that have performed well during inflationary periods maintain their momentum? Investors need to be discerning in their assessments since not all inflation ETFs are equally effective.
- In response to escalating inflation concerns, Jerome Powell and the Federal Reserve have revised their projections, suggesting that inflation might persist beyond 2025 at a rate higher than their 2% objective.
- With the reality of higher inflation, investors should contemplate incorporating bond market instruments like inflation protection ETFs into their portfolios. For example, the ProShares Inflation Expectations ETF (RINF) profits from the gap between nominal Treasury and TIPS yields.
- Amidst the potential for a bond market crash due to rising interest rates and inflation, the Fed's policy response will greatly impact the performance of various inflation-linked ETFs. For instance, the Simplify Interest Rate Hedge ETF (PFIX) benefits from increases in long-term interest rates and volatility.
- In light of the increasing likelihood of higher inflation, it is crucial for investors to evaluate the varying strategies offered by inflation ETFs such as VTIP, PFIX, RINF, and RAAX to determine which best aligns with their investment objectives and risk tolerance.
