Inflation concerns are on the rise again. The Federal Reserve’s latest Summary of Economic Projections showed central bank officials see inflation potentially ending in 2025 at 2.5%, above their previous forecast of 2.1% and higher than their 2% target. There is a growing possibility of a resurgence in consumer prices and investors should consider adding inflation protection to their portfolios.
The employment market is strong, economic growth is exceeding expectations, and potential inflation-inducing changes in fiscal and immigration policy loom large. The bond market has already accepted that the Fed may not further ease monetary policy. Ten-year Treasury yields have jumped 0.90% in the last three months due to the better economic outlook.
There are several ways to bet on the resurgence of inflation using ETFs. How the Fed responds to the threat of rising CPI, whether bond investors view inflation as temporary or long-lived, and whether inflation is a global or US-centric phenomenon will determine the performance of the various options.
Here are a few potential strategies to consider.
Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
VTIP focuses on short-term Treasury Inflation-Protected Securities (TIPS) with maturities of less than five years, providing exposure to inflation-linked bonds with reduced interest rate risk. With a management fee of just 0.04%, it is one of the cheapest ways to own TIPS.
Like Treasuries, TIPS are backed by the full faith and credit of the U.S. government. The most significant difference 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 level of inflation. Due to the fixed coupon component, TIPS are still sensitive to rising interest rates and can fall in price if yields rise with inflation.
VTIP would be a good alternative to a broad fixed-income ETF like AGG, which holds a mix of Treasuries, Agency MBS, and investment-grade corporate bonds. First, VTIP’s duration is much shorter because it only holds bonds with less than five years to maturity. The 2.4 year duration makes VTIP less sensitive to a jump in interest rates. Second, the inflation component of the TIPS in VTIP should provide additional return if CPI rises more than currently anticipated by the bond market.
Think of VTIP as a better ETF than AGG to hold during rising inflation, not as a stand-alone investment that will provide a material positive return.
Simplify Interest Rate Hedge ETF (PFIX)
PFIX uses long-term interest rate options to benefit from rising rates. It does not directly benefit from rising inflation. Instead, it targets increases in the 20-year interest rate through derivatives. The ETF gets its exposure to higher rates by purchasing 7-year options on the 20-year swap rate.
When inflation rises, the Fed usually responds by raising the overnight rate. Starting in 2022, for example, the Fed hiked the policy rate from 0.25% to 5.5% over a fifteen month period as inflation spiked to over 9%. Thirty-year bond yields rose approximately 3% from the start of 2022 to the fall of 2023, helping PFIX to generate an incredible 288% return during that time period.
Due to its use of options, PFIX offers leveraged upside potential when rates and volatility increase. However, the ETF is vulnerable to considerable capital loss if interest rates fall and implied volatility declines. With an expense ratio of 0.50%, retail investors get an institutional caliber strategy at a reasonable cost.
It is worth noting again that PFIX does not provide direct exposure to inflation. There is a scenario where inflation rises, and long-term interest rates fall. If the Fed acts early and forcefully by tightening rates again, short-term yields may rise, but long-term yields may not do anything or even fall.
PFIX will not perform if inflation increases without a corresponding rise in interest rates. PFIX does best when the bond market is surprised by higher-than-expected inflation and when the central bank is expected to react slowly to combat prices. The starting point of interest rates and volatility matters. The best time to buy PFIX is when both yields and option volatility yields are low. Since bond yields have already started to price in higher inflation, rates would have to keep moving higher for PFIX to add to its 10.5% gain in 2024.
The bottom line is that PFIX would be a suitable ETF if long-term rates and volatility rise quickly, whether that rise comes from inflation or another factor, such as investor concern over budget deficits and reduced 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 breakeven inflation rate is 2%, suggesting that investors expect inflation to average 2% per year 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 depends on changes in market inflation expectations, not actual inflation. The current 30-year break-even inflation rates is 2.29%. If investors reprice inflation expectations higher, RINF will produce positive returns. For example, inflation expectations have climbed approximately 0.24% since early September, and RINF has gained 5.1%.
Unlike VTIP, RINF has no direct exposure to interest rates, making it a pure play on inflation. RINF is a good choice for investors who want to bet on higher inflation expectations rather than on rising interest rates. If term premiums for long-dated Treasuries climb without an increase in inflation expectations, RINF will not perform.
The fund’s relatively low 0.30% management fee makes RINF a good way to take advantage of rising inflation expectations.
VanEck Inflation Allocation ETF (RAAX)
The bond market is not the only way to position for higher inflation. Certain other asset classes have demonstrated positive correlation with rising CPI. Investors can put together a portfolio of these assets with the expectation that past correlations will hold and that they will track inflation higher.
RAAX, for example, is an ETF that uses a diversified, actively managed approach, allocating to assets across commodities, natural resources, equities, real estate, and infrastructure—areas that have historically benefited from rising inflation. Gold is its largest holding with a 23% allocation.
The dynamic asset allocation helps adapt to changing inflation trends and economic conditions, and the exposure to commodities offers direct protection to rising input costs which can drive inflation higher. The strategy requires a longer investment horizon due to the imperfect short-term correlation between inflation and commodities, real estate and other equities.
Real estate, for example, tends to do well in inflationary environments but can suffer when interest rates, or debt costs, move significantly higher. Also, commodities tend to perform better when global demand increases, rather than just demand in the U.S. China, which accounts for approximately 50% of global commodity demand for, is currently suffering from deflation—not inflation—and bond yields are at record lows. China’s economic slowdown is impacting demand for copper, steel, oil, and other industrial inputs. Approximately 23% of the fund is invested directly in commodities, so this will impact RAAX’s performance.
RAAX probably performs better when rising prices are a global issue, not just a U.S. problem. Energy stocks, for example, may not do well if global demand softens at the same time as U.S. supply potentially grows under more relaxed regulations in the new Trump administration.
RAAX would be a good choice for investors who want to tweak their equity portfolio toward asset classes with a history of outperforming the broader market during periods of rising global inflation. The ETF returned a net 1.53% in 2022 after its 0.77% expense ratio when the S&P 500 lost 18.1%.
Which Inflation ETF To Choose?
Investors can position their portfolios for a change in realized or expected inflation in many ways. VTIP may outperform the broader bond market but is not likely to generate significant positive returns. PFIX is a good choice for investors who want to bet on rising long-term interest rates as a byproduct of inflation. RINF provides direct exposure to increasing break-even inflation levels. RAAX allows investors to allocate to sectors and asset classes that have historically outperformed during inflationary periods.
There are many questions to answer before picking an inflation-friendly ETF. How will the Fed and the market react to rising price levels? Will the Fed act quickly or take the view that inflation is transitory? How much inflation is already priced into the market? Will assets that have historically performed well when inflation rises continue to do so? Investors need to be nuanced in their views because not all inflation ETFs are created equal.
Read the full article here
