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PassiveBeat: An underinflated market for inflation-fighting funds

PassiveBeat: An underinflated market for inflation-fighting funds

While The ETF industry has enjoyed tremendous inflation- there have been more than 1,000 new products launched in the past three years - funds that help investors hedge against rising prices have been thin on the ground.

There are of course plenty of index-linked bond ETFs, but these are imperfect tools. Consider the past six months, when the UK inflation rate has climbed steadily from 1.3% to 2.3%. In that time, the Bloomberg Barclays UK Government Inflation-Linked Bond index has lost 3.5%.

The reason is not a malfunctioning index methodology, but that it is a basket of bonds, rather than a pure inflation hedge, so it has suffered in sympathy with the rest of fixed income from the fear of higher interest rates.

The outlook is not necessarily any brighter for index-linked gilts. As inflation hit 2.3% in February, the highest level since September 2013, the pound jumped to a three-week high against the dollar on the expectation that the Bank of England could be forced to start hiking now inflation is beyond its 2% target.

Don’t let me down

Inflation may also have further to run: Azad Zangana, senior European economist at Schroders, forecasts headline inflation reaching 3% in the months ahead and peaking around the end of the summer.

Investors seeking to profit from this inflationary environment, then, may not find index-linked gilts suitable if the period is to coincide with tighter monetary policy.

A new strategy from Lyxor is therefore propitiously timed. Listed in London in mid March with a total expense ratio of 0.25%, the awkwardly named Lyxor UK£ 10Y Inflation Expectations Ucits ETF adopts a more refined approach to inflation.

It essentially reflects exposure to a long position in 10-year index-linked gilts, but matched against a short position in conventional gilts of the same duration. It is thus more of a pair trade, benefiting if index-linked gilts outperform traditional sovereign bonds – something they have done by 10 percentage points over the past year and by one percentage point over the past six months.

The new ETF joins two related products launched last year for US and European inflation, both of which have outperformed their local standard inflation-linked indices since then.

Imperfect hedges

Even with this new addition, though, there is a dearth of UK ETFs focused solely on inflation. There is a multitude of equity and commodity ETFs that some will argue protect against inflation, but these are more accurately funds that have historically been positively correlated with inflation - at best partial proxies for inflation.

Investing solely in an inflation index would inevitably mean using derivatives, as the Lyxor ETFs do, which will rule them out for some. But there could still be ETFs that target inflation-beating returns without relying on index-linked bonds alone, in the manner of the ‘real return’ strategies popular among active managers.

There are some in the US, from providers such as IQ and WisdomTree, which take a multi-asset approach; while still heavy on index-linked bonds, they also hold commodities and equities for example.

None is a perfect way to capture inflation as an isolated variable, but a wider array of tools would nevertheless help investors as they confront this new environment.

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