Using ETFs to Manage Inflation Risks

While inflationary pressures may not be too pressing at the moment, conservatively positioned, income-oriented investors may be at risk if inflation spikes and erodes the purchasing power of portfolios. Consequently, people should consider alternative exchange traded fund investments to diversify their portfolios.

“Rising inflation has historically been a drag on equity and bond returns, making diversification beyond mainstream asset classes more essential,” Fidelity Investments analysts, led by Austin Litvak, said in a research note. “A strategic allocation to a basket of inflation-resistant assets may help investors mitigate these risks.”

The Fidelity analysts pointed to two major asset classes that have historically held up better in such environments.

First off, asset classes with long histories of reliable returns that outperform when inflation is rising include commodities, gold, commodity-producing equities and short-duration bonds.

For example, investors can look to something like the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), which provides exposure to multiple commodities, to gain broad commodities exposure or targeted ETFs like the SPDR Gold Shares (NYSEArca: GLD) for single commodity exposure.

Hard assets often perform well when inflationary pressures rise, a scenario that could benefit equity-based exchange traded funds such as the FlexShares Morningstar Global Upstream Natural Resource Index Fund (NYSEArca: GUNR). GUNR provides exposure to the rising demand for natural resources and tracks global companies in the energy, metals and agriculture sectors, while maintaining a core exposure to the timberlands and water resources sectors.

The actively managed Fidelity Limited Term Bond ETF (NYSEArca: FLTB) may also help investors shift down the yield curve to short-term debt as a way to diminish the negative effects of inflation.

Secondly, investors can look to asset classes with shorter histories of returns that make long-term analysis more difficult, such as real estate investment trusts, Treasury inflation-protected securities and leveraged loans.

For instance, the Fidelity MSCI Real Estate Index ETF (NYSEArca: FREL) tracks a portfolio of U.S.-based REITs that can hold their value when inflation rises since they generally own physical structures that generate steady yields based on rents, which can also rise along with prices.

Something like the iShares TIPS Bond ETF (NYSEArca: TIP) would be a good play on TIPS. TIPS are a type of Treasury security that is indexed to inflation as a way to shield investors from the negative effects of inflation. The securities’ par value rises with inflation as measured by the Consumer Price Index while interest rate remains fixed. TIPS also offer investors another layer of diversification as many aggregate bond funds exclude TIPS from their holdings.

Lastly, a senior secured, floating-rate bank loan option, like the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), includes a floating interest rate component, which fluctuates with market rates. The coupons on these loans adjust to movements in short-term rates, so if rates rise, the coupon rates will too, which may occur during inflationary periods.

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