Inflation Protection Shouldn't Be Complicated

By Aaron Levitt | November 08, 2009 AAA

Inflation is becoming the hot topic for many investors. As the economy collapsed, the U.S. and other world governments pulled out all the necessary stops in order to jump start the economy's heart. However, all these stimulus plans, tax rebates, low interest rates and spending initiatives are having unwarranted consequences: an increasing money supply and access to ultra cheap funds. All the signs are there for high inflationary environment going forward and investors would be wise to take notice.

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The Wall Street Jump
With a new panic comes new products and in the case of inflation, Wall Street once again has come to investors' rescue. New exchange-traded funds have been launched by provider IndexIQ in order to take the problem head on. The ETF hopes to provide correlation to changes in the U.S. inflation rate by providing a real return, or a return above the rate of inflation as measured by changes in the Consumer Price Index. The most recent offering is the IQ CPI Inflation Hedged ETF (AMEX:CPI).

CPI is an actively managed fund of funds, meaning that the ETF will invest its assets in that of other ETFs. Currently, CPI has a 91% weighting to bonds, specifically the iShares Barclays Short Treasury Bond (NYSE:SHV), a 7% weighting to gold, followed by minuscule percentage to the Japanese yen (NYSE:FXY).

The fund falls flat on a number of things, starting with the double-dipping of fees. CPI charges 0.65% in expenses to run the fund, followed by the expenses of each underlying ETF investment.

Second, the fund over-complicates the idea of inflation protection. Every portfolio should have some allocation to fighting inflation, but this should be viewed as insurance. You hope your home doesn't flood, but if it does you're protected. And considering that CPI's holdings are all very liquid funds on their own, why pay extra to have someone "manage" something that possibly doesn't need that much active management at all?

A Better Plan
For most portfolios a simple inflation fighting plan of attack is best. Using a small handful of ETFs you can gain enough protection and sleep well at night. Think of it as a buy and hold insurance policy.

Treasury Inflation Protected Securities (TIPS) are bonds backed by the full faith and credit of the federal government that provide a fixed coupon plus a rate that is adjusted based on changes in the Consumer Price Index (CPI). Using the iShares Barclays TIPS Bond (NYSE:TIP) which covers the United States TIPS market and the SPDR International Government Inflation-Protected Bond (NYSE:WIP) which covers these bonds on a global scale, investors can gain exposure to one the best tools for fighting inflation.

By adding exposure to commodities investors protect themselves from price changes in real goods. There are several commodity based exchange traded funds (ETFs) on the market to choose from. The iPath Dow Jones-AIG Commodity ETN (NYSE:DJP) follows 19 different commodity futures and is a more evenly-weighted index. Gold is also a great inflation hedge. The iShares COMEX Gold Trust (NYSE:IAU) holds actual gold in a vault for shareholders.

A declining greenback causes imports to be increasingly expensive, adding to an inflationary environment and rising prices. The PowerShares DB U.S. Dollar Index Bearish ETF (NYSE:UDN) is designed to duplicate the performance of being short the U.S. dollar against a basket of foreign currencies. These include the, Japanese yen, British pound, Canadian dollar, Swedish krona, Swiss franc and a nearly 57% weighting in the euro.

The Bottom Line
Inflation protection does not need to be complicated. By adding exposure to TIPS, commodities and other currencies, we can protect our portfolios from higher prices and a falling dollar. The preceding ETFs offer a simple buy-and-hold approach to adding this insurance. (To learn more about protecting your portfolio from inflation, see Curbing The Effects Of Inflation.)

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