This week’s August CPI print might not have been a worst case scenario for the markets, but it was pretty ugly. Investors have been waiting and hoping for a more dovish stance from the Fed since the beginning of this summer, but so far they haven’t gotten it. In fact, the Fed has firmly rejected this notion at every turn.
Because of this, the market was not prepared for this week’s inflation rate of 8.3%. Yes, it was lower than last month, but the street was expecting 8.1%. More hopeful investors were expecting a little under 8%. Missing the inflation report would have been one thing and likely led to a sell-off in shares. In this case, the gap between expectation and actual was much larger than normal. Hence, there is a BIG sell-off in stocks.
The biggest problem I see today is not that the August report missed estimates. The thing is, inflation is likely to be persistently higher for a while. The core inflation rate, which ignores groceries and energy but includes rents, healthcare costs and the like, has picked up again over the past month. That’s the more stubborn inflation that doesn’t usually go away once priced in. If someone pays $2,000 a month for rent, it usually stays at $2,000 a month even if headline inflation falls or there’s a recession. People are getting used to paying for it, so there’s no reason to lower the cost.
Inflation will eventually fall again, but that may take months. Also, we’re just one geopolitical event away from seeing energy or food prices spike again.
Investors often use TIPS as an inflation hedge, but there are other ways to do this. Options, interest rate swaps, government bonds, commodities, and inflation-sensitive stocks can all provide varying degrees of inflation protection with varying results.
Each of the ETFs I’ll be covering here uses one or a combination of these non-TIPS strategies. In the interests of full disclosure, most of these ETFs are small. Only one has more than $15 million in assets, so you need to watch out for trading costs if you’re considering buying them.
But each of them has the potential to be a very useful tool for investors if inflation lingers for a while.
Ionic Inflation Protection ETF (CPII)
CPII is an actively managed fund that aims to provide positive returns in times of high or rising inflation, as well as in times of rising interest rates and fixed income volatility. In other words, all of the scenarios that we are experiencing right now. To do this, he invests in inflation swaps on the CPI, swaptions on US interest rates and TIPS.
This fund only launched in June of this year, so we don’t have a complete data set to work with yet. What we do know is that most of the portfolio is currently invested in short-dated TIPS, but there are other allocations in both cash and interest rate swaps. The interest rate swap position is logical. When inflation expectations rise, interest rates tend to rise as well, and that’s exactly what we’ve seen over the past year.
In its short history, CPII has gained just over 2%, compared to losses of around 1% for TIPS and Treasuries. Income seekers will no doubt be drawn to the fund’s current yield of 14%.
Amplify Inflation Fighter ETF (IWIN)
IWIN also takes a multi-asset approach and generally consists of various inflation-sensitive stocks and commodities that aim to benefit directly or indirectly from inflation. I really like this fund because it takes one of the most diverse approaches to creating an inflation-sensitive portfolio.
Today, IWIN’s portfolio consists of allocations to miners, commodities, land developers, commodity REITs, home builders and real estate technology stocks, as well as the more traditional interest rate hedges. Commodity holdings include bitcoin futures contracts, gold, and soft commodities. It’s one of the most diversified products on the ETF market and helps avoid exposure to a single asset class not performing as expected. Within the equity shell, the fund is approximately 40% large-cap and 60% mid- and small-cap.
IWIN is also new this year. It’s an actively managed fund, which is what you want for this type of strategy, and the expense ratio of 0.85% is actually pretty reasonable given the active management costs and what you get for the price.
Global X Interest Rate Hedge ETF (IRHG)
Global X has always been at the forefront of thematic ETFs and adds another nice option with IRHG. This fund is not directly an inflation hedge, but it does provide a hedge against a sharp rise in US long-term interest rates, which makes sense given the high correlation between interest rates and inflation rates. It invests in long interest rate swap options (swaptions) and long positions in short-dated US Treasuries, the latter used primarily for cash management purposes.
IRHG is also new this year (an issue that’s obvious considering high inflation hasn’t been a major concern for decades up until this year). However, his timing was great. Since its inception in July, the 10-year government bond yield has risen from around 2.8% to 3.4%. That has resulted in a return of more than 11%. Again, this isn’t a pure inflation hedge like some of the other funds on this list might be, but given that inflation rates and interest rates tend to move in the same direction, it still qualifies as a hedge.
Square Interest Rate Volatility and Inflation Hedge ETF (IVOL)
IVOL is the largest and most famous of this group, launched in 2019. This Fund seeks to protect purchasing power, reduce inflation risk, benefit from increases in volatility and yield curve steepening and provide inflation-protected income. IVOL invests in a combination of TIPS and dynamically managed fixed income options.
IVOL was the original interest rate/inflation hedging strategy before it became more popular this year. While returns from TIPS and swap options have benefited overall performance, it is important to remember that government bonds still make up the bulk of the portfolio. That means total returns have suffered in 2022. IVOL is still outperforming the broader Treasury market by about 2% this year, but is still down about 10% year over year.
Global X Interest Rate Volatility & Inflation Hedge ETF (IRVH)
If IRHG is an interest rate hedge, IRVH is more your traditional inflation hedge. It has three main objectives – to hedge relative interest rate movements resulting from a steepening of the US yield curve, to benefit from periods of market stress when interest rate volatility increases, and to provide inflation-protected returns.
IRVH ends up looking very much like CPII – mostly TIPS with a side of interest rate swaps. Similarly, it also pays monthly payouts, but carries the cost advantage. CPII has an expense ratio of 0.70%, but IRVH only charges 0.45%.
IVOL gives us a good insight into how it and strategists like CPII and IRVH can work in adverse conditions. Of the three, I’d still stick with IVOL for now based on its history and asset base, but IRVH has a chance of becoming the pick in the future. Global X has a solid business model behind it and is a well-known name in the ETF world. It’s still very small and needs to grow to become a better option.
IRHG is perhaps the purer play on inflation, odd as it sounds, because it is an interest rate hedge. Although inflation has skyrocketed and yields on TIPS have risen, TIPS have been hurt by the broader bond bear market. As such, they haven’t offered nearly as much protection as investors might have hoped. Pure interest rate hedging became much more closely correlated with rising inflation rates and would have provided much better protection against inflation.
However, IWIN is a really good choice. Because it’s invested in stocks, commodities, and other asset classes, it’s still subject to the downside risk that comes with investing in such things. However, the broad diversity and comparatively lower correlation with other asset classes is an advantage and a nice alternative to TIPS.
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