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Hedging Inflation with ETFs

A look at inflation and the various ways to hedge the risk with ETFs.

Michael Rawson, 06/04/2010

You have seen the doomsday headlines. The Fed is printing money and government debt has ballooned. This can only mean one thing: inflation, right? In this article, we offer some tips on how to hedge inflation risk using various ETFs. We then take a look at the prospects for inflation and explain why we feel the risk is overhyped.

Hedging Inflation Risk
Money has three central purposes. It serves as a medium of exchange, (prevents the need to go back to the barter system), it is a unit of account (a method to value transactions or measure worth), and it serves as a store of value (this is what concerns investors most). So the best way to protect ourselves from inflation is to store wealth in something that is of fixed supply that cannot be easily manipulated.

So to hedge the risk of inflation, we want to have ownership stake in assets rather than paper currency. One option is to invest in equities through a fund such as Vanguard Total Stock Market ETF VTI. The problem with investing in equities is that although a firm's assets and revenue should increase in value with inflation, there is the potential for these values to fall due to the negative impact on profitability due to inflation. Some estimates even show a negative relationship between stock returns and inflation. Even though stock prices and earnings are both quoted in nominal terms, the price/earnings ratio can shrink. For example, we have seen gasoline refiners suffer from their inability to pass along high oil prices. However, over the long term, firms and consumers will adjust to inflation and nominal stock prices should reflect higher inflation. A similar argument could be made for funds that invest in real estate, such as iShares Dow Jones US Real Estate IYR. Although the value of the land should keep up with inflation, in the short term, the economic disruption caused by real estate could have a negative impact on rental income.

Another option is to invest in commodity ETFs like SPDR Gold Shares GLD. Gold is an ideal commodity hedge because the global supply is relatively stable (at least more so than IOUs written on scraps of paper). An advantage of GLD is that it owns physical gold, rather than entering into futures transactions, which can be an impacted from the negative roll yield associated with contango. Despite the fact that an inflation hedge should be only a small portion of your assets, perhaps 5%, now may not be the best time to buy gold. During the past 10 years, the S&P 500 has lost 8% while gold is up 350%; that trend is clearly not sustainable, particularly when commodities do not generate profit growth or create innovation and their prices tend to be mean reverting.

Another option for hedging inflation risk is through bonds. iShares Barclays TIPS Bond TIP holds bonds that will increase in par value with inflation. Their quoted yield looks lower that ordinary bonds but that is because it is a real rate of return, which will be supplemented with the inflation rate after the fact. As we mentioned above, these bonds are not currently pricing in an inflation crisis. Vanguard Short-Term Bond ETF BSV offers only a nominal rate, not an inflation-protected real rate, but because it is invested in short term bonds, the rate resets often so it will increase with inflation with little capital loss. Long-term bonds, on the other hand, can suffer a large capital loss due to unexpected inflation.

In order to reduce the risk of one single currency losing value, you could hold a diversified basket of currencies. Probably the best option among foreign currency related ETFs is SPDR DB International Government Inflation-Protected Bond WIP, which offers two forms of inflation protection through the TIPS bonds as well as through currency diversification. Foreign currency exposure could also be obtained through iShares MSCI EAFE Index EFA, although this would entail the same problem of a lack of a strong relationship between inflation and equity returns mentioned above. PowerShares DB G10 Currency Harvest DBV provides currency exposure, but because it follows an active approach, there are no guarantees it will perform well when the dollar weakens. PowerShares DB US Dollar Index Bearish UDN uses futures contracts to bet against the dollar, so it should do well if inflation is higher in the United States than it is abroad.

The Prospects for Inflation
In response to the Great Recession, the Fed has purchased debt obligations from the government, the mortgage market, and even from insolvent financial institutions. It has done this on an unprecedented scale all in an attempt to stabilize the financial markets.

To some degree, they are monetizing existing debt, which means they are paying the bills of the government by printing money. In simple terms, printing money without actually increasing the total amount of goods and services available is inflationary. However, the Fed has embarked on this program not with the intent of financing government spending, but instead to prevent deflation, which is the bigger concern. PAGEBREAK

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