If you're concerned about inflation, you've got a good reason. Inflation has hit its highest level since 1982 to an increase in the level of prices of the goods and services that households buy.
What do you do when commodity prices are surging? High inflation can be the result of a hot economy or companies. As a result, many companies may choose to charge more because they realize they can raise prices without losing customers.
Let's walk through how ETFs can hedge against inflation and demonstrate a few exchange-traded funds (ETFs) that are effective inflation hedges.
How Can ETFs Hedge Against Inflation?
First, a quick definition of exchange-traded fund (ETF) and inflation.
An ETF is a basket of securities that tracks an underlying index. ETFs comprise a mix of stocks and bonds. ETFs offer diversification, low expense ratios, and tax efficiency that can help assist many investors.
Inflation is typically measured by two common statistics — the Consumer Price Index (CPI), a measure of the price in aggregate of consumer goods and services, and the Wholesale Price Index (WPI), a measure of the price of goods at the production level.
Some inflation can be good for equities but surging costs can hurt a company’s profits. Rising rates can help the equity markets have so far shaken off inflation fears but the bond market is another story. Rising rates negatively impact bonds because of the inverse relationship between price and yield.
ETFs track the performance of many things, including currencies, commodities, gold or natural resources. You can use many different ways to hedge against inflation.
3 ETFs to Consider
Let's consider three ETFs you may want to consider adding to your portfolio.
The Vanguard Materials ETF tracks the performance of the MSCI US Investable Market Materials 25/50 Index. The sector is made up of companies in a wide range of commodity-related manufacturing industries:
- Construction materials
- Forest products
- Related packaging products
- Mining companies
- Producers of steel
The ETF offers a broad representation of the target sector and large-, medium- and small-cap companies and carries 117 stocks. The net assets of its 10 largest holdings are the following:
- Linde Plc
- Sherwin-Williams Co.
- Air Products and Chemicals Inc.
- Freeport-McMoRan Inc.
- Ecolab Inc.
- Newmont Corp.
- Dow Inc.
- DuPont de Nemours Inc.
- PPG Industries Inc.
- International Flowers and Fragrances Inc.
The iShares Core U.S. Aggregate Bond ETF tracks the investment results of an index made up of the total U.S. investment-grade bond market.
The high-credit-quality portfolio is invested in other levels of investment-grade bonds, which makes it more stable compared to stocks.
The fund invests at least 90% of its net assets in component securities of its underlying index and in investments that have economic characteristics identical to the economic characteristics of the component securities of its underlying index.
- BlackRock Cash Funds Instl SL Agency BISXX
- Federal National Mortgage Association
- Government National Mortgage Association
- United States Treasury Notes
- United States Treasury Bonds
- United States Treasury Notes
The Vanguard Short Term Inflation-Protected Securities ETF tracks an index that measures the performance of inflation-protected public obligations of the U.S. Treasury that have a remaining maturity of fewer than five years.
Treasury Inflation-Protected Securities (TIPS) provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, measured by the Consumer Price Index. When a TIPS matures, you receive the adjusted principal or original principal, whichever is greater.
TIPS pays interest twice a year at a fixed rate. The rate is applied to the adjusted principal interest payments rising with inflation and falling with deflation.
The fund allows investors the potential for less volatility of returns relative to a longer-duration TIPS fund. Investors invest in bonds backed by the full faith and credit of the federal government and the principal is adjusted semi-annually based on inflation.
Other Ways to Hedge Against Inflation
What are some other ways to hedge against inflation? Let's look into another few ways to hedge against inflation.
- Real estate: Owning real estate (whether your primary residence or a vacation home) is a great way to hedge against inflation with a long-term mortgage, especially at historically low rates. Owning a home means you’ll have the potential for its value to increase over time.
- Stocks: Stocks are a long-term vehicle for hedging against inflation, even if it might seem that you shouldn't invest in certain stocks. That's why you need to shop around to find the right stocks by understanding the basic underlying fundamentals of individual stocks. Excellent companies' stocks should climb over time and the best companies chew through inflation no problem because of their structure and leadership.
- Gold: Gold has traditionally been a great inflation hedge. Gold tends to fare well when inflation rates go higher. Investors often view gold as a store of value during tough economic times, and it has succeeded in this purpose over long periods. You can also invest in metals through an ETF.
Consider Inflation Hedge ETFs for Your Portfolio
If you want to diversify your investments, hedge your risk or get exposure to a certain industry or market, there are many advantages to including ETFs in your investment portfolio.
When you want an inflation hedge, ETFs may be the perfect asset for your portfolio because it combines the ease of trading individual stocks and depends on a simple way to diversify a portfolio.
However, it's important to remember that there are some dangers of an ETF. There are many ways an ETF can stray from its intended index. This tracking error can deviate from what you're looking for in an investment, as an investor. Indexes do not hold cash but ETFs do, so you'll face a tracking error in some situations.
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