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Investing Strategy: Inflation Isn't Going Away; Here Are 5 ETF Hedges For Your Portfolio

Investors often use TIPS, but options, interest rate swaps, Treasuries, commodities and inflation-sensitive stocks can also offer protection.

This week's August CPI print perhaps wasn't a worst case scenario for the markets, but it was pretty ugly. Investors have been anticipating and hoping for a more dovish stance from the Fed since early this summer, but so far they've failed to get it. In fact, the Fed has firmly rejected that notion at every turn.

Because of that, the market wasn't prepared for this week's 8.3% inflation print. Yes, it was down from last month, but the street was expecting 8.1%. More hopeful investors were anticipating something below 8%. A miss on the inflation report would have been one thing and it probably would have resulted in a sell-off in equities. In this case, the gap between between expectation and actual was much larger than normal. Thus, we get a BIG sell-off in stocks.

The biggest issue I see today isn't that the August report missed estimates. It's that inflation is probably going to be persistently higher for a while. The core inflation rate, which ignores food and energy but includes rents, healthcare costs and things like that, went up again last month. This is the stickier inflation that tends not to go away once it's been priced in. If somebody is paying $2000 a month for rent, it usually stays at $2000 a month even if overall inflation comes down or there's a recession. People get used to paying it, so there's no reason to drop the cost.

Inflation will eventually come back down, but it may be months from now. Plus, we're only one geopolitical event away from energy or food prices shooting higher again.

Investors often use TIPS as inflation protection, but there are other ways to do it too. Options, interest rate swaps, Treasuries, commodities and inflation-sensitive stocks can all offer varying degrees of inflation protection with different outcomes.

5 ETF Hedges To Protect Your Portfolio From Inflation

5 ETF Hedges To Protect Your Portfolio From Inflation

Each of the ETFs I'm going to profile here use one or a combination of these non-TIPS strategies. In the interest of full disclosure, most of these ETFs are small. Only one has more than $15 million in assets, so you'll need to pay attention to trading costs if you consider buying them.

But each of these has the potential to be a very useful tool for investors if inflation decides to stick around for a while.

Ionic Inflation Protection ETF (CPII)

Ionic Inflation Protection ETF (CPII)

Ionic Inflation Protection ETF (CPII)

CPII is an actively managed fund that looks to generate positive returns during periods of high or rising inflation as well as during periods of rising interest rates and fixed income volatility. In other words, all of the scenarios that we're experiencing right now. It does this by investing in inflation swaps on the CPI, swaptions on U.S. interest rates and TIPS.

This fund only debuted in June of this year, so we don't have a fully data set to work with yet. What we do know is that most of the portfolio is currently invested in short-term TIPS, but there are other allocations to both cash and interest rate swaps. The interest swap position is logical. When inflation expectations rise, interest rates tend to rise as well and that's exactly what we've seen over the past year.

Over its brief history, CPII has gained a little over 2% compared to roughly a 1% loss for both TIPS and Treasuries. Income seekers will no doubt be enticed by the fund's current yield of 14%.

Amplify Inflation Fighter ETF (IWIN)

Amplify Inflation Fighter ETF (IWIN)

Amplify Inflation Fighter ETF (IWIN)

IWIN also takes a multi-asset approach and is generally comprised of various inflation-sensitive stocks and commodities aimed to benefit directly or indirectly from inflation. I like this fund quite a bit because it takes one of the most diverse approaches to creating an inflation-sensitive portfolio.

IWIN's portfolio today consists of allocations to miners, commodities, land development companies, commodity REITs, homebuilders and real estate tech names as well as the more traditional interest rate hedges. Within the commodity holdings are bitcoin futures contracts, gold and agricultural commodities. It's one of the most diversified products on the ETF market and helps avoid the risk from any single asset class that doesn't perform as expected. Within the equity sleeve, the fund is about 40% large-caps and 60% mid- and small-caps.

IWIN is also new this year. It's an actively-managed fund, which is what you want for this type of strategy, and the 0.85% expense ratio is actually fairly reasonable given the active management costs and what you're getting for the price.

Global X Interest Rate Hedge ETF (IRHG)

Global X Interest Rate Hedge ETF (IRHG)

Global X Interest Rate Hedge ETF (IRHG)

Global X has always been a leader in thematic ETFs and adds another nice option in IRHG. This fund isn't directly an inflation hedge, but it provides a hedge against a sharp increase in long-term U.S. interest rates, which makes sense given the high correlation between interest and inflation rates. It invests in long interest rate swap options (swaptions) and long positions in short term U.S. Treasury securities, the latter of which is mainly utilized for cash management purposes.

IRHG is also new this year (a theme that's obvious given how high inflation hasn't been a major problem for decades up until this year). Its timing, however, has been great. Since its July inception, the 10-year Treasury yield has risen from around 2.8% to 3.4%. That's led to a return of more than 11%. Again, this is not a pure inflation hedge in the way that some other funds on this list might be, but given how inflation rates and interest rates tend to move in the same direction, it still qualifies as a hedge.

Quadratic Interest Rate Volatility & Inflation Hedge ETF (IVOL)

Quadratic Interest Rate Volatility & Inflation Hedge ETF (IVOL)

Quadratic Interest Rate Volatility & Inflation Hedge ETF (IVOL)

IVOL is the largest and most well-known of this bunch having launched in 2019. This fund seeks to protect purchasing power, mitigate inflation risk, profit from an increase in volatility and a steepening of the yield curve, and provide inflation-protected income. IVOL invests in a combination of TIPS and dynamically managed fixed income options.

IVOL was the original interest rate/inflation hedge strategy before it became more popular this year. While the TIPS and swap option income has helped overall performance, it's important to remember that most of the portfolio is still Treasury securities. That means total returns have suffered in 2022. IVOL is still outperforming the broader Treasury market this year by about 2%, but it's still fallen about 10% on the year.

Global X Interest Rate Volatility & Inflation Hedge ETF (IRVH)

Global X Interest Rate Volatility & Inflation Hedge ETF (IRVH)

Global X Interest Rate Volatility & Inflation Hedge ETF (IRVH)

If IRHG is an interest rate hedge, IRVH is more of your traditional inflation hedge. It has three primary goals - to hedge relative interest rate movements arising from a steepening of the U.S. interest rate curve, to benefit from periods of market stress when interest rate volatility increases and to provide inflation-protected income.

IRVH ends up looking a whole lot like CPII - mostly TIPS with a side of interest rate swaps. Similarly, it also pays distributions on a monthly basis, but carries the advantage on cost. CPII has an expense ratio of 0.70%, but IRVH charges just 0.45%.

Conclusion

IVOL gives us a good view into how it and strategist like it, such as CPII and IRVH, can perform in adverse conditions. Of the three, I'd still stick with IVOL for now based on its history and asset base, but IRVH has a chance of becoming the choice in the future. Global X has a solid business model behind it and is a well-known name in the ETF world. It's still really small and needs to grow to become a better option.

IRHG is perhaps the more pure play on inflation, strange as it sounds because it's an interest rate hedge. Even though inflation has soared and yields on TIPS have taken off, TIPS have been hurt by the overall bear market in bonds. Therefore, they haven't provided nearly as much protection as investors may have hoped for. The straight interest rate hedge has been much more closely correlated with rising inflation rates and would have done a much better job protecting against inflation.

IWIN is a really nice choice though. Because it's invested in stocks, commodities and other asset classes, it's still exposed to the downside risk that comes with investing in such things. The broad diversity and comparatively lower correlation with other asset classes is an advantage though and is a nice alternative to TIPS.

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