February 17, 2011

ETF Investors on the Hunt for Inflation Hedges as CPI, PPI Rise

Schwab's Iachini points to TIPS, currency, commodity and stock funds as good bets

As talk heats up about whether inflation is creeping into the U.S. economy, investors and advisors are on the hunt for exchange-traded funds (ETFs) that can act as a hedge against rising prices.

One market player who’s experiencing the effect of rising inflation worries is IndexIQ CEO Adam Patti. His IQ Real Return ETF (its clever ticker: CPI), launched in late 2009 to provide a real return of 2% to 3% above the U.S. consumer price index’s (CPI) rate of inflation, has recently seen an unprecedented increase in volume.

While the ETF may be relatively small—assets currently total just under $13 million—it has seen a significant rise in trading volume to 50,000 shares a day from 30,000, Patti said in an interview on Tuesday.

“People are afraid of inflation, and last year they weren’t,” Patti said. “This is an asset allocation product, and we don’t expect a lot of trading, so this is a nice pick-up for us. Inflation is clearly on the rise in energy and food prices, and we think the IQ Real Return ETF will be our breakout product this year.”

The rules-based, index-heavy IQ Real Return ETF’s core holding is in short-term Treasuries and 10 other asset classes rather than in more volatile government-issued Treasury Inflation Indexed Securities (TIPS), Patti (left) said. The ETF’s top holdings include CurrencyShares Japanese Yen Trust, Ishares Russell 2000 Index Fund, iShares MSCI Emerging Markets Index and PowerShares DB Gold, according to Morningstar’s profile of the ETF.

Inflation buzz was kept alive this week as data on both the consumer price index (CPI) and the producer price index (PPI) show the U.S. cost of living is on the rise. True, the nation’s inflation number currently stands at a low annual rate of 1.6%, but the prices of key goods that consumers buy daily are rising steadily. This rise, along with long-term fears of an out-of-control  federal deficit, is stoking investor demand for inflation protection.

The U.S. Labor Department reported Thursday that the consumer price index for January increased by 0.4%, the same rate as in December. Core CPI, which excludes the more volatile prices of food and energy, gained 0.2%, just above economists’ expectations.

Higher energy prices pushed up the headline number, with some help from food and apparel, said the PNC economics team, led by Chief Economist Stuart Hoffman, in an analyst note. Gasoline prices continued to increase on a seasonally adjusted basis, up 3.5% for the month and now up 13.4% from a year ago. Food prices, they said, rose 0.5% in January.

“The good news for the Federal Reserve is that the threat of deflation is rapidly retreating, the bad news is that inflation is broadening from a just a commodity-specific phenomenon,” the PNC economists wrote.

Indeed, producer prices that eventually get passed on to the consumer also are rising. On Wednesday, the Labor Department reported that the core producer price index for finished goods rose 5% in January—it’s biggest jump in 27 months.

Many ETFs that can act as a hedge against inflation are normal ETFs that investors might hold anyway, said Michael Iachini (left), a director and ETF expert with Charles Schwab Investment Advisory, in an interview on Tuesday.

“I haven’t seen a pattern of product launches that are specifically tied to inflation-fighting ETFs,” Iachini noted. “They’re out there, certainly, and I think investors are worried about inflation, but I don’t think that has translated into a flood of products on the market to address that investor desire.”

ETF investors who are concerned about inflation can fight it four different ways, according to Iachini. Notably, his pick of products mirrors the sort of investment vehicles found in the IQ Real Return ETF’s core holdings.

1) TIPS. “Clients think of Treasury Inflation Protected Securities for good reason when they worry about inflation, because they rise in value as inflation increases,” Iachini said. “If you see 10% inflation in CPI down the line, your TIPS will be going up 10% in value along with the prices of everything else. A lot of clients find some comfort in that. They know that their bonds will keep pace with inflation.

But the downside is they’re still bonds, usually long-term, and that means they’re usually vulnerable to movements in interest rates.” Iachini also warned that investors don’t like TIPS’ current coupon rates because they are very low and provide no income. Schwab sells a TIPS ETF (SCHP) as does iShares Barclays (TIP) and other fund companies.

2) Foreign currencies. “You can think of inflation as the eroding value of your currency,” Iachini said. “If the U.S. dollar is becoming worth less, other currencies out there may be worth more on a relative basis. You have to be careful here, because other currencies could have inflation as well. If the euro is inflating faster than the dollar, buying euros isn’t going to help you. But if there are currencies that are more stable as opposed to a rising dollar, then getting

yourself direct exposure to the currency could help protect you. I wouldn’t advise most investors to go into foreign currencies lightly because they’re very different from stocks or bonds. If you buy a foreign currency ETF, what the ETF is often holding is bank deposits in foreign banks, and that’s it.”

3) Commodities. “This is another traditional inflation hedge,” said Iachini, who recently published an article on Schwab’s website about spot and futures prices in commodity ETFs. “When you have inflation, the prices for commodities tend to go up with everything else.  So you can hedge your money by putting your money into ‘stuff,’ like gold or oil. Commodities are much easier now for investors to access thanks to the introduction of ETFs.

"Before that, investors didn’t want to deal with the security issues of storing gold in their house or a bank vault, and oil is pretty impossible for investors to hold onto. Having access via a regular brokerage account to buy commodities is nice, and that’s what ETFs provide.  But again, it’s a different asset class from what most investors are used to, so they have to do their homework, especially with commodities ETFs that use future contracts, where you have to worry about contango.”

4) Stocks. “Inflation is prices going up for things, and companies are things, too. If you look historically at stock returns, you can actually see that stock prices tend to have a positive correlation with inflation,” Iachini said. “As prices in general go up, stocks in general go up. That said, there is the concern that you could have a pricing panic.

"If you look at periods of hyper-inflation, that’s certainly not good for the stock market. But in periods of mild inflation, that will probably affect the prices of companies, too, but stocks are a pretty good hedge against inflation. If you’re also worried about the value of the dollar, you might want to consider foreign stocks. There, you get both the tendency of stocks to go up with inflation as well as the protection against the dollar falling.”

Despite all the buzz, however, LPL Financial economist and investment strategist John Canally is not convinced that inflation is really something to worry about, despite CPI and PPI concerns as well as fears of a bloated U.S. deficit.

“If you look at observed inflation over the year, it’s benign. CPI is currently up 1.6%, but over the last 30 or so years, inflation has been running closer to 3%,” Canally said Thursday. “By any measure it’s low, though beneath the surface you’re seeing hefty gains for what we buy frequently, in particular dairy, meat, cooking oils, gasoline and home heating oils.”

Indeed, it’s highly unlikely that the United States will see the sort of inflation that it experienced back in the 1970s, he noted. At present, there’s still plenty of slack in the economy, including a high unemployment rate, empty office space, no unions pressing for higher wages and outsourcing of jobs to emerging markets, where growth is hotter.

“In 1973, nobody was saying, ‘We’re going to move your job to Taiwan,’” Canally said. “I think the risks are still balanced, and if anything, still tilted toward deflation. The Fed has become quite good at fighting inflation, but it’s not doing a good job communicating about the country’s low-inflation environment.”

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