Inflation and ETFs

ETF MarketPro recently connected with Salvatore Bruno, Chief Investment Officer of IndexIQ, to learn more about inflation hedging and the firm’s new funds – IQ ARB Global Resources ETF (GRES) and  IQ CPI Inflation Hedged ETF (CPI).


ETF MarketPro (ETFMP): For your latest product launch, why did do you decide to focus on solutions that help investors hedge against inflation? 

Bruno: With the large increase in fiscal and monetary stimulus coming out of Washington over the last year, we believe that the seeds for higher inflation have potentially been sown.  Given the economic downdraft that we have experienced, there is excess capacity in the system that may keep inflation contained in the short run.  However, as the economy begins its recovery, we run the risk that with so much excess liquidity flooding the system, an increase in the velocity of money (how fast money is turned over) can trigger a sharp rise in inflation.  It will be up to the policy makers in Washington to try to balance the risks of removing the liquidity too early and choking off the fledgling recovery or leaving the liquidity in the system for too long and possibly stoking inflation.

ETFMP: What is your outlook for inflation over the next 12 – 18 months and longer term? 

Bruno: We think that given the excess capacity in the system and the probable slow climb back from the economic abyss, inflation is not likely to accelerate quickly in the short run.  However, unless the excess liquidity can be removed with great precision, there is a real risk of a sharp uptick in inflation in the medium term.

ETFMP: Can you say more about the methodology underlying the CPI and GRES indexes?  How was it developed? 

Bruno: The methodology for CPI is very similar to the methodology that we employ for our hedge fund replication suite of products.  It is regression based and tries to capture the relationship between a group of relevant factors and the key variable, in this case, inflation.  The objective of the product is to deliver a 2-3% real return (return above inflation) each year with the goal of providing investors a low volatility mechanism for guarding against the corrosive effects of inflation on their purchasing power.  In periods where inflation is low and stable, we can expect an allocation to short term treasury bonds to provide some of the real return.  We also expect exposure to longer term treasuries, equities and other asset classes that perform well in a benign inflation environment.  As inflation increases, the expectation is that the allocation will shift more towards assets traditionally viewed as inflation hedges namely commodities (oil and gold) and real estate.  Given the short term horizon of the short term treasury bonds, one might also expect that the yields on these instruments would rise quickly in inflationary periods and thus we would see a significant allocation to them as well.

GRES is constructed very differently as it is primarily an equity based portfolio.  While global natural resources can provide a hedge against inflation, the primary objective of GRES is to provide efficient exposure to global resources as a diversifier to the equity portion of the portfolio. We attempt to do so by identifying companies whose primary business is tied to one of 8 global resources. We then using a combination of valuation and price performance of the global resource sectors to over- and under- weight the sectors around an equal weighted average.  This allows the portfolio to remain well diversified across all 8 global resource sectors.  Lastly, to amplify the commodity effect and mitigate the equity effect, we have a managed short exposure to the global equity markets.

ETFMP: Why do you believe that other broad-based commodity products are overweight in energy?  What is a better commodity allocation for hedging against inflation? 

Bruno: Many of the other commodity products use the market value of futures contracts for the commodity, the value of the commodity produced during a given year or some combination of the two.  As oil is an important commodity to the economy, it has a much larger value of production in any given year than do other commodities. It is also very heavily traded in a large and deep futures market.  These two factors tend to drive the large overweight in energy.

Oil and energy based products can be effective as an inflation hedge.  However, given the important role that oil plays in the economy, the prices can (and often do) trade for reasons other than inflation.  So an over weight in oil can subject investors to excessive volatility in their portfolios.

We believe that a broader base of commodities can help to provide an effective hedge against inflation as they affect many different aspects of the consumer’s life.  Whether it is the cost of grains, food and fibers or livestock affecting prices at the supermarket or the cost of industrial metals in consumer durable products, one can see that the effect of rising resource prices can have an important effect on a consumer’s lifestyle.  Taking a more broadly based view global resources to hedge inflation may be more effective than an over concentration in a single commodity.

ETFMP: TIPS are a hugely popular investment right now.  Can you give an example of a scenario where TIPS might not be the best approach to hedge against inflation?

Bruno: TIPS bonds themselves have a built-in inflation hedge by construction.  The principle adjusts periodically to reflect inflation and an investor that holds the bond until maturity will get a real return upon maturity.  The problem, however, is that TIPS bonds are more correlated to other treasury bonds than to inflation.  So as interest rates move up and down, the price of the TIPS bond will move in the opposite direction introducing potentially large amounts of volatility. If the investor needs to convert the TIPS bond to cash before it matures, they can be facing a large loss of principle if interest rates have risen and the bond price has fallen.

ETFMP: Gold and other precious metals are also experiencing tremendous demand  — what do you see as the potential drawbacks for holding gold as an inflation fighting tool relative to your funds?

Bruno: Gold has had a tremendous run up in price in part because of its widespread use as a as a store of value to hedge against inflation but also because of it utility as a safe asset in turbulent times.  So gold does not always efficiently reflect inflation expectations because of its dual roles.  As investor sentiment ebbs and flows, gold can be traded quickly to reflect the market’s prevailing level of fear. This can lead to far higher levels of volatility than an investor may be willing to accept in the inflation hedge portion of their portfolio.

ETFMP: What factors would make an investor decide between the IQ ARB Global Resources ETF and the IQ CPI Inflation Hedged ETF?

Bruno: We believe that both CPI and GRES can be important additions to a well diversified portfolio.  While both can help to hedge inflation risks, the objective of CPI is clearly much more geared towards providing a low volatility way to protect against inflation.  GRES is an equity based product that can help dampen overall portfolio volatility through its exposure to commodity oriented equities and the short global equity market exposure.  GRES can be expected to deliver a more robust series of returns than would CPI.

ETFMP: How much of a portfolio should an investor allocate to inflation hedging assets?

Bruno: While we are not in the business of giving asset allocation advice, we have seen studies on the appropriate weight of TIPS in a portfolio.  Depending on an investor’s outlook for inflation, TIPS can be anywhere from 5% to 15% of a well-diversified portfolio*. We clearly believe that CPI can be a viable alternative to TIPS and therefore can be used as a replacement for that portion of the portfolio. The same allocation study has a range of commodity based exposure from 10% to 25%.  As GRES is designed to provide exposure to commodities, it can be thought of as a substitute or complement to an investor’s existing commodity assets.

To learn more about hedging against inflation with ETFs, see the case study in the Investor Center or visit IndexIQ’website.
*WSJ Research