ETFs to Play the Inflation Trade

NEW YORK ( TheStreet) -- Capital markets have been trying to sort out whether or not there will be meaningful price inflation because of all the liquidity injections and other steps being taken to stoke the economy or whether there will be deflation as we could have many more years of writedowns and poor economic activity ahead of us.

Protecting against inflation or trying to speculate on an inflationary outcome has been easy to do with various TIPS products or precious metals. Deflation has been tougher other than buying bond funds as a deflationary environment is good for bonds. A couple of new exchange traded notes from Deutsche Bank ( DB) allow for more precise protection or speculation, depending on the end user's objective.

The PowerShares DB US Inflation ETN ( INFL) will go up when the bond market perceives inflation risks increasing and the PowerShares DB US Deflation ETN ( DEFL) will go up when the bond market perceives deflation risks increasing. I used the phrase "when the bond market perceives" because each note is tied to the spread between the yield of TIPS versus the yield of regular treasury bonds of like maturities. When the TIPS outperform it is viewed as an expression of inflation concerns increasing which is when INFL should outperform and when TIPS underperform regular treasury bonds it is viewed as an expression of inflation concerns decreasing which is when DEFL should out perform.

Each of the notes charges a 0.75% expense ratio. The indicative intra day value (IIV), which is the exchange traded product equivalent of the term net asset value, of the notes will move by $0.10 for each point change in the respective underlying indexes. As a practical matter this will be difficult to track in real time without a Bloomberg Terminal but Deutsche Bank has been maintaining the indexes since July 25 of this year and in that time the index underlying INFL is down 8.31% (through November 28) while the index underlying DEFL is up 8.54%.

Mentioning the returns of the two is noteworthy because in the same four month period the iShares Barclays TIPS Bond Fund ( TIP) was up 4.53%. This shows that INFL and DEFL can move a lot in a short period of time. They can add value for people looking to protect or hedge a portfolio as a little exposure to the notes might be able to go a long way but also be a positive for speculators as more than 8% in four months in which there was no panic in the US or other form of market malfunction is a decent sized move.

The price movement of both indexes and the TIP fund also isolates another important point. We know that in the four months studied, the market was less concerned about inflation because the index for DEFL was the one to go up but TIP, which is also supposed to be a proxy for inflation also went up. This reveals that TIP does not necessarily move on the spread between TIPS and regular treasury bonds. It also shows that TIP can move on the direction of interest rates whereas movement of the notes is about the relationship between two different products.

This becomes a complicating factor for owning INFL and DEFL. The strategy is more of an institutional strategy so the funds, like many exchange traded products, are democratizing in their nature but anyone interested in these funds needs to spend the time necessary to learn the dynamics of how this spread has worked and what it really is influenced by. Tools that make sophisticated strategies available to investors for whom they were previously unavailable is either a good thing or a bad thing based on how they are used and they way they are used is driven by whether or not a proper effort was put in to learn about them.

One last point that is always worth mentioning is that exchange traded notes are unsecured debt obligations of the issuer which in this case is Deutsche Bank. While a failure of Deutsche Bank is unlikely, if it happens then note holders would be wiped out.

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At the time of publication, Nusbaum was long TIP, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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