An Alternative Hedge Against Inflation
Written by Michael Fabian, May 02nd, 2013
With the recent spat of volatility we’ve experienced in gold, as measured by the SPDR Gold Trust (GLD) which fell roughly 13% in two trading days in the month of April, I’ve become more intrigued with a different tactic for conservative investors hedging the risk of inflation in their portfolios. Gold has many other long term benefits than just hedging inflation, but for the purposes of this article, I want to focus on another low volatility option. Income investors that might not have the stomach for large day-to-day price swings in commodities could look to inflation protected bonds as a way to increase their principal if the consumer price index begins to tick higher.
However, instead of a plain vanilla option like the iShares Barclays Inflation Protected Securities ETF (TIP), which only allows you to benefit if inflation rises in the United States. A more exotic and alternative means to play this useful area of the bond market is the PIMCO Global Advantage Inflation Linked Bond ETF (ILB). Instead of being a creditor to one nation, the actively managed PIMCO ETF enables investors to own inflation linked securities globally, in both developed as well as emerging market countries. I particularly like that the fund is currently holding outsized positions in economically developed nations with stronger balance sheets than we have domestically, such as Austrailia, Canada, and Mexico.
Inflation can rise or fall at different times in unrelated locations around the globe, so ILB will work to further diversify your exposure to various consumer price movements. One thing to keep in mind is that the fund primarily invests in longer dated securities, and as a result carries a higher effective duration of 6.57 years, so changes in interest rates could lead to greater volatility. I will point out that more recently, ILB didn’t responded with much of a pullback in concert with the rise in interest rates we witnessed earlier this year. So I believe its a safe to say that the active management component of this ETF will seek to compensate for changes in interest rates by possibly shortening duration.
Another key consideration to ILB is its ability to gather fixed income and currency exposure towards countries that are driving global growth. A good example of this tactic within its portfolio is the 20.17% position in Brazilian securities, currently its second largest holding behind the United States. Although ILB is a newer fund with limited operating history, looking at a chart over the last 1 year, ILB is handily outperforming exposure to U.S. TIPS alone. With a divergence of approximately 5%, in this low yield environment, that outperformance certainly kept pace with domestic inflationary pressures.
One quirk about ILB that I’m not particularly fond of is that it doesn’t have a consistent dividend payment, however the stated SEC yield of the holdings within its portfolio indicate a future yield of 4.54%. New investors in the fund should be mindful that the price of the fund is currently trading at a 0.88% premium to its NAV, however that has been the average since the fund’s inception, so minimal caution is warranted. The funds expense ratio is also higher than the average index product due to management costs, it currently resides at 0.60%. For conservative investors I think the new PIMCO ETF presents excellent risk-to-reward characteristics in parallel with other inflation fighting assets. Although it would not emulate the same long term traits of owning commodities, I believe its a great investment in lieu of traditional investments in U.S. Treasury inflation protected securities alone.