The perfect inflation hedge has yet to be found. That’s unfortunate, since US inflation has taken a big leap, increasingly looking for an investment that will thrive in times of high inflation.
A perfect hedge against inflation must meet two distinct criteria, and no one has yet figured out how to create an investment vehicle that meets more than just one of these two goals. These two criteria include a short-term goal that is correlated with inflation and a long-term goal of outperforming inflation.
Stocks provide a good illustration. Over the past 200 years, they have produced the highest real returns of any major asset, which is why stocks are considered by many to be good inflation hedge. However, when measured over the short term, stocks are often negatively correlated with inflation – falling as inflation heats up, and vice versa.
does not do much better, although it is considered an ideal inflation hedge. On the one hand, its short-term correlation with inflation is better than stocks, but not by much. The correlation coefficient between monthly changes in gold bars and the Consumer Price Index (CPI) has been only 0.12 since 1970, compared to minus 0.06 for the S&P 500.
Of course, if gold were perfectly correlated with inflation, this coefficient would be 1.0.
On the other hand, gold over the long term hasn’t produced really good returns like stocks: Over the past 50 years, the S&P 500’s total annual return has been 3 percentage points higher than gold. In other words, gold does a better job of meeting one of the two ideal inflation hedges while doing a worse job at the other.
What about TIPS – Treasury Inflation Protected Securities? They are a prime example, as they did a great job of meeting short-term goals while falling short of long-term goals. That’s because, by design, TIPS returns are tied to changes in CPI. However, TIPS does a very poor job of accomplishing long-term goals. In fact, their real yields are now negative.
ETF is designed to be an inflation hedge
A number of different exchange-traded funds have been created in an attempt to fill this gap in the investment landscape. However, most of them are just brief, according to an analysis done by Nicholas Rabener, founder and CEO of FactorResearch in London. He reports that the correlation of these ETFs with the CPI is surprisingly low and the funds with the best record are generating positive real returns.
The longest-recorded inflation-themed ETF is the IQ Real Return ETF
was established in October 2009. The objective of the ETF is to “provide investors with a hedge against the US inflation rate by providing a ‘real return’, or return above the rate. inflation rate, as expressed by the Consumer Price Index (‘CPI’). “Over the past decade, this ETF has generated 1.2% annualized returns – 0.8 percentage points lower than the CPI’s 2.0% return on an annualized basis.
At the same time, this ETF has shown a low correlation with inflation. For example, over the past decade, the correlation coefficient of monthly changes in the ETF and the CPI has been 0.14 – hardly any higher than the 0.12 coefficient I found in the case of gold.
I reached the same conclusion when correlating this ETF with changes in expected inflation, rather than actual inflation. For expected inflation, I focus on Inflation expectations model developed by the Federal Reserve Bank of Cleveland. The correlation coefficient in this case is 0.12, worse than the 0.14 that appears when focusing on real inflation.
Another inflation-focused ETF is the ProShares Inflation Expectation ETF
was created in January 2012. Since then, it has lagged the Consumer Price Index by 2.8 percentage points year-on-year, with an annual return of negative 0.8% versus a plus 2.0%. for CPI.
On the other hand, the correlation of RINF with inflation is higher for the IQ Real Return ETF, although still low. The correlation of monthly changes for RINF and realized inflation is 0.30 and 0.23 when focusing on expected inflation.
To be fair, the jury doesn’t like these two ETFs, since most of their history has been in a low-inflation environment. It is impossible to know how they will perform if higher inflation is only temporary. The jury is also out in the case of some inflation-themed ETFs with even less history.
But we still have enough history to be skeptical that there is an investment instrument that simultaneously meets both the short- and long-term goals of an ideal inflation hedge. Therefore, you need to decide which of the two is the most important to you, and then find the investment that satisfies that goal with the least risk.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be contacted at firstname.lastname@example.org
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