ETFs for Inflation Hawks

07/02/2008 12:00 am EST

Focus: ETFS

Jeffrey Ptak

Director of Exchange Traded Securities, Morningstar, Inc.

Jeffrey Ptak, director of exchange-traded securities for Morningstar, finds some ETFs to help  protect your portfolio against inflation.

Gasoline, corn flakes, tires-you name it, the price has probably risen sharply in the last year or two.

Given the influence that commodities can have on prices, the recent flurry of new commodity-linked exchange traded funds (roughly one-third of the 100-plus ETFs launched thus far in 2008) is not entirely unwelcome. For instance, investors seeking to hedge their exposure to, say, rising food prices could grab a "food" ETF from off the shelf.

There's nothing wrong with the current batch of commodity ETFs, per se. But investors should be mindful of a few factors before jumping in whole hog.

First, investing in futures-the tack that virtually all of these ETFs take-is not equivalent to owning the physical commodities. Futures prices are indeed a function of spot prices, but futures returns can vary, sometimes sharply, from returns at spot prices.

For instance, while West Texas Intermediate (WTI) crude oil prices rose nearly 60% through 2007, United States Oil (Amex: USO), an ETF that invests in WTI futures contracts, rose only 48%. The disparity can arise [because] when contracts farther from expiration carry higher prices than those nearer to expiry, futures returns typically lag returns at spot prices, and vice versa when the curve is "downward sloping."

The upshot is that the shape of the futures curve can somewhat limit the effectiveness of commodity futures investments as hedges. It can also be difficult to correctly dial in one's unhedged exposure to various prices.

Finally, investing in commodities is not for the faint of heart. While exchange traded notes such as iPath Dow Jones-AIG Commodity Index Trust ETN (NYSEArca: DJP) tamp down volatility by investing in broad-based commodities baskets, investors considering a narrower vehicle should keep in mind the inevitable bumps along the way.

Rather than utilize commodity ETFs to build and maintain inflation hedges in an a la carte way, I'd go with inflation-indexed bonds. There's one relatively new ETF, SPDR DB International Government Inflation-Protected Bond (Amex: WIP), which does exactly that, but with a twist.

Instead of investing exclusively in US Treasury inflation-protected securities (TIPS), the SPDR fund tracks a benchmark of inflation-linked government bonds issued by more than 15 foreign nations, spanning developed and developing markets alike. As such, the fund provides a one-stop hedge against inflation in numerous geographic locales. That could come in handy, given the likelihood that inflation will tick up abroad.

Additionally, since the fund's holdings are denominated in the local currency, investors gain incremental diversification away from the greenback.

Of course, there are also a few drawbacks. The SPDR fund's portfolio is likely to be quite interest-rate-sensitive, [so] if rates rise from their currently low levels, you could lose money. In addition, the fund's success as an inflation hedge will depend on how faithfully each government's inflation index captures price changes.

All the same, if you're an inflation hawk, I'd opt for the SPDR fund over commodity ETFs.

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