ETFs for Investors Fearing Deflation

By Michael Johnston

NEW YORK ( TheStreet) -- First, the good news: Fears about runaway inflation appear to have been overblown. Now for the bad news: The opposite may be worse.

For months, wary investors have been eagerly watching consumer price index (CPI) reports. But instead of racing toward the double digits, inflation has slowed. That has sparked fears of deflation, a rare but serious economic condition that has some of the world's most prominent investors concerned.

Pimco's Mohamed El-Erian recently told Bloomberg that the U.S. faces a 25% chance of deflation and a double-dip recession. Jan Hatzius of Goldman Sachs ( GS), another in a growing group of "deflationistas," sees CPI increases near zero in the near future and views a decline in prices as a real possibility. Hatzius says the tremendous amount of spare capacity in the U.S. economy will make it difficult for companies to raise prices, thereby increasing the risk of deflation.

Deflation can be devastating. When prices are falling, consumers are likely to delay purchases, waiting for costs to slide further before making a cash outlay. In a deflationary environment, sitting on a pile of cash becomes an attractive investment option with a positive real yield; the prospect of investing that money becomes rather unappealing. Moreover, borrowing money becomes undesirable because any loan will have to be repaid in dollars that are worth more than the dollars borrowed.

There are other reasons why deflation is disliked. Falling prices increase the burden of debtors. Finally, when prices are falling, wages often decline, too, either in the form of nominal cuts or upticks in unemployment.

For investors looking to add some "deflation defense" to their portfolios, there isn't a silver bullet that will thrive as prices slide. But there are a number of options that tend to perform relatively well:

1. Long-term bonds: Deflationary environments are generally bad for stocks, since profits tend to decline as prices fall. But deflation can be good news for fixed-income investors. That's because of the implications of the "fixed" part of the asset class name -- as prices slide, the real value of fixed coupon payments rises. In general, longer-duration securities will perform better in deflationary environments, since the coupon payment is locked in for an extended period of time.

Ideas: iShares Barclays 20+ Year Treasury Index Fund ( TLT), Vanguard Long Term Corporate Bond ETF ( VCLT) and Market Vectors Long Municipal Bond ETF ( MLN).

Zero coupon bonds, known as "strips," can provide solid returns if deflation kicks in. The securities allow investors to lock in fixed rates and reinvest at those rates. Pimco's 25+ Year Zero Coupon U.S. Treasury Index Fund ( ZROZ) is the best option for establishing exposure to this corner of the government bond market.

2. Dividend-paying equities: Some investors embrace equities of companies that make significant dividend payments as an alternative means of protecting against deflation. The dividend payments made by these securities are similar to the coupon payments made by bonds. Because most companies seek to avoid reducing dividends at all costs, dividend streams are unlikely to dry up unless equity markets enter into a severe depression.

There are a number of ETFs that focus exclusively on companies that offer the most attractive dividend yields. Some of the most popular include: Claymore/Zacks Dividend Rotation ETF ( IRO), PowerShares Dividend Achievers Portfolio ( PFM), First Trust Dow Jones Global Select Dividend Index Fund ( FGD), iShares Dow Jones Select Dividend Index Fund ( DVY), SPDR S&P Dividend ETF ( DWX) and WisdomTree's suite of dividend-weighted ETFs.

3. Cash: In deflationary environments, cash is king. Even when the yield is close to zero, the purchasing power of a dollar increases as prices slide. For investors looking to park assets in a low-risk security, there are interesting ETF options. Currently, there are six ETFs in the Money Market ETFdb Category, including: PIMCO Enhanced Short Maturity Fund ( MINT), Barclays Short Treasury Bond Fund ( SHV) and SPDR Barclays Capital 1-3 Month T-Bill ETF ( BIL).

4. Inverse ETFs: Because deflation is bad for equities, some risk-tolerant investors may be intrigued by the idea of establishing short exposure to stock markets. The funds in the Inverse Equities ETFdb Category offer a way to short most major indices, including domestic and international benchmarks: ProShares Short S&P 500 ( SH), ProShares Short Russell 2000 ( RWM) and ProShares Short MSCI EAFE ( EFZ).

Another interesting idea is short exposure to commodities because natural resources are always vulnerable to falling prices. There are a number of funds in the Inverse Commodities ETFdb Category, including PowerShares DB Agriculture Short ETN ( ADZ), PowerShares DB Base Metals Short ETN ( BOS) and PowerShares DB Commodity Short ETN ( DDP).

5. Other ideas: Most investors view IndexIQ's CPI Inflation Hedged ETF ( CPI) as an inflation hedge, but because this ETF seeks to generate a "real return" above the CPI, it can be a valuable tool in deflationary environments. There's also the volatility ETNs from iPath -- the S&P 500 VIX Short-Term Futures ETN ( VXX) exhibits a strong negative correlation with equity markets. Because deflation is bad news for stocks, it may give VXX a boost.

None of the funds profiled above are surefire solutions to deflation. The economic conditions that often accompany falling prices can be complex and can have unpredictable impacts on financial markets. But for investors looking to protect against deflation, they may be worth a closer look.

At the time of publication, Johnston had no positions in the securities mentioned. ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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