Investing in ETFs to guard against inflation

Amid soaring inflation, investors may want to consider ETFs based on Treasury inflation-protected securities (TIPS), which are bonds issued by the U.S. government that are indexed to inflation.

Steven Leong, head of product with iShares Canada, said investors are seeing the wisdom in incorporating some form of inflation protection or inflation sensitivity, especially on the fixed-income side of the portfolio.

“In general, we had gotten used to inflation being persistently low for a really long time. Thinking about fixed-income portfolio construction in the context of inflation risk had not been top of mind,” Leong said. “I would say it’s top of mind today, and probably will continue to be for some time. It may be a permanent feature as investors internalize lessons from this period we’re living through.”

Four years ago, Mackenzie Investments launched the first TIPS ETF (NEO: QTIP) in Canada. “The product has been quite successful. It has allowed many investors to integrate some protection against inflation into their portfolios,” said Laurent Boukobza, vice-president and ETF strategist with Mackenzie Investments.

And in 2021, iShares Canada launched a Canadian-dollar hedged 0-5 Year TIPS Bond Index ETF (TSX: XSTH) that has drawn over $200 million in net inflows. In the U.S., BlackRock’s short-term TIPS products have seen over $4 billion in inflows this year alone.

“Year to date, fixed income [has] been a challenging area of the market. But TIPS, especially short-term TIPS, have been one of the brighter spots,” Leong said. So far this year, inflation-linked bonds with inflation adjusted coupons have outperformed nominal bonds with fixed coupons by about 3.25%, he added.

In a TIPS ETF, capital and distributions are adjusted according to changes in the consumer price index. “This year, at times when inflation was much higher than expected, TIPS ETFs offered returns more than 4% higher than those of nominal bonds over a similar period thanks to protection against inflation,” Boukobza said.

Strategy diversification

Five-year break-even inflation rates in the U.S. are 2.84%, which is the expected level of inflation baked into the pricing of the inflation-linked bond, Leong said.

“So, whether it is going to perform better or worse than a nominal bond ultimately comes down to [whether] those expectations [are] too high, too low, or just right. If they’re just right, then your nominal bonds and your inflation linked bonds should have very similar performance,” he said. “Where the inflation-linked bond should be expected to perform better is where actual inflation is going to come in hotter than expected inflation.”

Leong said a proven inflation hedge is investing in the parts of the market most affected by inflation pressures: energy, commodities and agriculture, for example.

Another way to guard against inflation is to turn to infrastructure ETFs. “These holdings have been performing very well since the start of the year,” Boukobza said. “In this sector, we generally have well-established companies that do business with the government. Because they have the ability to pass price increases onto consumers, they do not need to reduce their profit margins and can avoid being adversely affected by inflation.”

Variable-rate loans are other investments to consider when inflation is rising. “Coupons are usually adjusted every three months, which means that when rates increase, these products will have a higher distribution rate and offer more income,” Boukobza said.

Leong agreed, adding that coupon payments adjust with short-term interest rates.

“That means in a rising rate environment you’re potentially going to earn more interest over time,” he said. “The other benefit is that, because of that dynamic, the value of the bonds or the [net asset value] of the fund doesn’t have interest rate sensitivity. So, whereas a lot of fixed-income investments will lose value due to interest rates going up, something like a floating-rate note will generally be much less sensitive.”

ETFs that offer exposure to gold are also a safe investment against inflation.

“Various asset categories will perform relatively well depending on where we are in the inflation cycle. As appropriate, investors can strategically over- or underweight their exposure to optimize their portfolio,” Boukobza said.

“What we would really want investors to consider is where, in their strategic asset allocation, they are thinking about inflation. Are they thinking about building in some protection? Strategic allocations to TIPS for example? Or strategic allocations to commodity-sensitive type of equities? That feels like a kind of reasonable takeaway from the episode that we’ve gone through,” Leong said.

“It’s a great unknown whether this episode is temporary and we’ll return to long term low inflation rates, but it’s possible that more volatile and higher inflation could be with us for a while to come.”