ETF Strategies for an Elevated Inflationary Environment Ahead

Investors can use exchange traded funds to prepare their portfolios to guard against inflation’s risks.

In the recent webcast, Inflation: Preparing Portfolios for a Shifting Environment, Brian Griggs, managing director, portfolio strategist, Nuveen, explains that investors will have to adapt to a new normal as the Federal Reserve has raised interest rates for the first time since December 2018, with inflation continuing to run hot and unemployment rates still falling. Meanwhile, the war in Ukraine and the resulting energy price shock are making the path of policy highly uncertain from here.

Griggs also notes that we may be in uncharted territory, as investors can’t really use the rising rates of the 1970s as a definitive guideline, since inflation and unemployment rates are trending in opposite directions.

Meanwhile, Griggs argues that while the Fed’s hawkish pivot has already impacted long-term inflation expectations, the pace of tightening will be key in answering how quickly inflation moderates. Consequently, allocators should not overreact to higher trailing inflation.

Looking ahead, even if inflation moderates, it will have investment implications. Griggs projects that higher average inflation going forward could be a headwind for traditional allocations. Additionally, he contends that inflation may moderate, but it should remain higher on average than during the last decade.

In this type of environment, the traditional 60/40 investment portfolio is already buckling under the strain, with U.S. government bonds underperforming. Griggs points out that traditional fixed income hasn’t provide its usual price return buffer and warns that asset allocators should perhaps get used to it.

“It’s time to reinvent the portfolio playbook,” Griggs says.

Griggs believes that investors should position for elevated, not runaway, inflation as inflationary pressures settle at an above-average norm. An elevated inflationary environment isn’t anything new for the U.S. economy. Since 1988, in 40% of quarters, inflation ran at greater than the five-year average. In this type of elevated inflationary environment, the best-performing asset categories include public REITs, U.S. large-cap core, U.S.- small-cap, and emerging market equity.

As investors look for ways to adapt investment portfolios for an elevated inflationary environment, Alex Graf, ETF specialist, institutional and ESG models, Nuveen, advises them to stick to quality, undervalued opportunities and dividends in the equity markets. Investors should also look for short-duration bonds to limit rising interest rate risk or duration risk. Additionally, he believes that investors can find opportunities in short-term real estate investment trusts.

To help investors gain exposure to these strategies, Graf points to ETFs like the Nuveen ESG Large-Cap Value ETF (BATS: NULV), the Nuveen ESG Mid-Cap Value ETF (NUMV), the Nuveen ESG Dividend ETF (Cboe: NUDV), the Nuveen Enhanced Yield 1-5 Year U.S. Aggregate Bond ETF (NYSEArca: NUSA), and the NuShares Short-Term REIT ETF (BATS: NURE).

At Nuveen, the money manager employs several other ESG criteria to better target companies that exhibit socially responsible characteristics. Nuveen applies an ESG rating to capture an issuer’s performance on significant ESG risks relative to peers, a controversy score that captures an issuer’s exposure and response to event-driven controversies, a controversial business investment component that captures an issuer’s activity in industries that may cause significant social harm, and low-carbon criteria that captures the carbon intensity of an issuer based on involvement in specific industries.

The three ESG factors cover three broad categories. Environmental refers to climate change, greenhouse gas emissions, resource depletion (including water, waste and pollution), and deforestation. The social aspect covers working conditions, including child labor, community and indigenous populations, operations in conflict zones, health and safety, employee relations, and diversity. Lastly, the governance factor is based on executive pay, bribery, corruption, political lobbying and donations, board diversity and structure, and tax structure.

NUSA tries to reflect the performance of the BofA Merrill Lynch Enhanced Yield 1-5 Year US Broad Bond Index, which is represented by a modified version of the more widely observed BofA Merrill Lynch 1-5 Year US Broad Market Index.

The Enhanced Index does not weight components by market capitalization, instead opting to assign components into various categories based upon asset class, sector, credit quality, and maturity. The smart beta indexing methodology then utilizes a rules-based process to include higher weights to categories with higher yields while maintaining risk and credit quality at levels similar to those of the Base Index.

Lastly, NURE tries to reflect the performance of the Dow Jones U.S. Select Short-Term REIT Index, which is comprised of real estate investment trusts that invest in residential or commercial real estate with a shorter-than-average lease duration than REITs investing in other sectors.

NURE focuses on REITs with short-term lease agreements, which may be less volatile and sensitive to interest-rate changes than longer-term REITs. These types of shorter-term REITs may be a good way for income-minded investors to access yield generation in a rising rate environment, as short-term contracts allow businesses to reprice and adapt to changing market environments more quickly. Due to the REITs’ structure, which allows most revenue to be distributed as income to shareholders, businesses’ prudent reactions could translate to higher returns for investors.

Additionally, the short-term REIT segment has exhibited improved risk/return characteristics compared to the broader REIT market. They exhibited higher returns in all measured time periods, coupled with lower volatility over the long term, and the short-term segment showed a similar dividend profile over a five-year average despite recent declines.

Financial advisors who are interested in learning more about investment portfolio strategies can watch the webcast here on demand.