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If compound interest is an investor’s best friend, inflation is her worst enemy. Currently, inflation rates are rising around the world. In this blog, we will take a look at ways in which you can use ETFs in the US markets to hedge against inflation.
US consumer inflation reached its highest level in more than four decades in May 2022, due to surging energy and food costs. The consumer price index increased by 8.6% in May compared to the same month a year ago, the fastest increase since December 1981. The price increase in May was mostly a result of a sharp rise in energy prices which rose by 34.6% from a year earlier and the price of groceries which increased by 11.9% in the same period.
It is not that easy to establish a direct relationship between inflation and stock market returns. The general wisdom is that for stock investors, shares can act as a hedge against inflation in the long run. However, an investor needs to prudently evaluate her investments in a high inflation rate scenario.
Certain categories of ETFs can provide investors with a simple and effective way to make the most of rising prices and high inflation rates. These ETFs often tend to perform better when inflation is high. Let us take a look.
TIPS ETFs as a hedge against inflation
TIPS or Treasury inflation-protected securities are one option to protect your portfolio against inflation. TIPS work like any other bond. However, they are indexed to inflation to protect investors in a rising inflation environment.
You can buy TIPS from the US Treasury or through a bank or a broker. The more convenient way is to invest in TIPS ETFs such as the Schwab U.S. TIPS ETF (SCHP) or the iShares TIPS Bond ETF (TIP) which are composed of TIPS securities.
One of the risks with TIPS investments is that the CPI may fail to reflect the actual inflation. In that case, the inflation protection offered by the plan may not be able to protect the investor’s purchasing power.
Commodity ETFs as a hedge against inflation
TIPS or Treasury inflation-protected securities are one option to protect your portfolio against inflation. TIPS work like any other bond. However, they are indexed to inflation to protect investors in a rising inflation environment.
You can buy TIPS from the US Treasury or through a bank or a broker. The more convenient way is to invest in TIPS ETFs such as the Schwab U.S. TIPS ETF (SCHP) or the iShares TIPS Bond ETF (TIP) which are composed of TIPS securities.
One of the risks with TIPS investments is that the CPI may fail to reflect the actual inflation. In that case, the inflation protection offered by the plan may not be able to protect the investor(’s purchasing power.
Commodity ETFs as a hedge against inflation: Usually, commodity prices rise with inflation because they fuel the inflation rate. For example, a rise in the price of oil and gas prices will contribute to a rise in inflation even though they may not closely mirror the actual rate of inflation. Historically, commodities have provided protection against inflation.
Gold is considered an inflation hedge as the value of gold often increases with a decline in the purchasing power of the dollar. While 2021 was a lackluster year for Gold, it has a solid start this year. The yellow metal has gained more than 5% in the first quarter of 2022, its biggest quarterly gain since September 2021. Investors can get easy exposure to Gold via Gold ETFs such as the SPDR Gold Shares (GLD), which is designed to track the price of gold and is a convenient and cost-effective way to access the gold bullion market.
Similarly, oil ETFs may also act as an inflation hedge. An example would be the United States Oil Fund (USO), which invests primarily in futures contracts for light, sweet crude oil, other types of crude oil, diesel-heating oil, gasoline, natural gas, and other petroleum-based fuels. Another option could be the iShares U.S. Oil Equipment & Services ETF (IEZ), which provides exposure to companies that provide equipment and services for oil exploration and extraction.
Commodity ETFs, on the other hand, are designed to provide exposure to a range of commodities. One such ETF, Shares S&P GSCI Commodity-Indexed Trust ETF (GSG), seeks to track the results of fully collateralized investments in futures contracts on an index composed of a diversified group of commodity futures. As a result, it provides exposure to a broad range of commodities.
REIT ETFs as a hedge against inflation
Real estate prices and rentals also tend to increase with inflation. Real Estate Investment Trusts (REITs) can thus also act as an inflation hedge. REITs are companies that own or operate income-producing real estate. ETFs also give you an option to invest in REITs. An example of a REIT ETF is the iShares Global REIT ETF (REET) whose objective is to track the investment result of an index composed of real estate equities in developed and emerging markets.
It is important to remember that while ETFs in the categories mentioned above may act as a hedge against inflation, there is no guarantee that it will always be the case. It is important that you consult your financial advisor and invest according to your risk appetite.
