Inflation, Prices and ETF Strategies
Author: Marco Santanche
Inflation can impact investment strategies substantially. Hedge funds that prosper when inflation is low might find it hard to produce consistent returns during inflationary times. But how do the most important inflation-hedging strategies actually perform from an historical perspective, and what does that tell us?
Inflation consists of the change in the consumer price index over (usually) a one-year horizon. It reflects the increase in price for a basket of goods. It is published by numerous sources, depending on the country, the US one being on the BLS website with a one-month lag. Its measurement is not perfect, as it is subject to a number of errors, including sampling error, substitution bias, quality bias and more.
It is one of the most important macroeconomic data, as many look at CPI to identify changes in their own expenses, and it is relevant for both businesses and householders. However, there are multiple ways to build a basket of goods and some are more relevant than others for some specific businesses. In general, policymakers mostly refer to Core CPI, which excludes the prices of energy and food as they are very volatile and might add noise to the statistical measurement.
There are several research pieces from major financial companies trying to examine how strategies behave in different inflation regimes. Protection from inflation risk is a desirable, yet rare, attribute in ETFs.
Candidates to hedge against inflation
When thinking about derivatives, systematic strategies or machine learning, the average investor thinks that the topic is too complicated, too far removed from his savings management or retirement planning. However, this is where ETFs come in to help: they allow us to be exposed to any possible strategy, while keeping our investment simple, easily accessible and low in cost.
Nevertheless, when looking at the plethora of possibilities in the space, being confused is a logical reaction. Passive and active ETFs are already very different, leaving aside all the technicalities of asset classes, strategies, dividend/coupon distribution, hedging, and so on. This is why we are going to dissect some of the strategies which are conceptually related to inflation, and we will measure their actual performance afterwards, to understand if they truly help in providing investors with real returns when inflation comes.
In this piece, we will consider the following ETFs:
Let’s try now to dive a bit deeper into what these strategies do, how they differ, and what would be optimal in inflationary times.
Trend following
Trend-following strategies take long and short positions based on the current trend in the market. This style originated at the beginning of the twentieth century, with Charles H. Dow (yes, the Dow-Jones index creator) being the first to express a trend as a series of higher highs and lower lows.
There are many ways to implement this in practice. The suggestion from Dow might be seen as a breakout strategy, where the trend is identified at a new, higher (or lower) level when compared with previous (recent) historical prices. But the practical nuances of the methodology can make a big difference.
Some investors regard trend-following strategies as a good hedge against inflation. Conceptually, they should be able to capture both positive and negative long-term trends, so that they keep their profits running on either side.
We will investigate two ETFs belonging to this family, WTMF and DBMF, which both invest in multiple asset classes in order to achieve their long-term goals.
Treasury Inflation-Protected Securities (TIPS)
It is absolutely logical to think about direct hedges to inflation, as for example TIPS. As the name states, they are government securities which not only provide a fixed income, but also protect it against inflation, adjusting their face value by the officially reported inflation rate. As they are tailor-made against inflation, we need to analyze how they work and if they truly help us in hedging this type of risk.
In this exercise, we will cover four different TIPS ETFs, including the popular iShares TIP.
Real returns
In finance, real returns consist of returns net of inflation. In practice, such strategies might be developed in a variety of manners, including targeting asset classes with upside potential in case of inflation (e.g. energy, TIPS) and ad-hoc macro/tactical asset allocation models. In this exercise, we will cover the IQ Real Return ETF and SPDR Multi-Asset Real Return ETF.
Asset class hedging
In addition to these groups, we are also going to identify some single asset classes which would normally see their prices increasing with inflation – for instance, real estate and commodities. We will observe how they actually react during different regimes.
Data sources and inflation periods
After sourcing ETF data from Yahoo and CPI data from the Federal Reserve website, we had to calculate inflation, which consists of the percentage change from the CPI level 12 months ago. Although simple, we must also keep in mind that inflation data is published with a lag, but for this experiment, we do not want to forecast or time inflation, but rather observe if the increase in price (measured ex post) coincides with good performance for our strategies.
We define inflationary times as periods where a change in year-on-year CPI has been at least 3%. This simple definition will define two periods:
- A non-inflationary period going from 2019-05-09 to 2021-03-31
- And an inflationary period going from 2021-04-01 up to 2023-05-31
Let us now observe graphically what happened to our strategies in the two sub periods.
When inflation is low
In this chart, we see a general, negative performance. The Covid-19 pandemic clearly makes a difference, as all strategies had a large drawdown. However, if we observe closely, we can see some different patterns. Let us subset the charts based on the different investment concepts:
Every strategy has its own behavior, and it is not dramatically different amongst competitors. TIPS seem to appreciate even if we are in non-inflationary times. Trend Following exhibits a similar pattern but with a dominant one (DBMF), while Commodities and Real Estate underperform dramatically. The Real Returns strategy is suboptimal, although we observe two different risk-adjusted profiles.
We now see how SCHH, DBC and RLY (REITs, Commodities and Real Returns) are much riskier than the other assets in the portfolio. Moreover, some of the ETFs seem to be very inefficient, as they have better counterparts in terms of both returns and risk, such as WTMF.
We should also keep in mind that these macro trends are not considering the whole economic and financial outlook. It might be that there are more important factors determining the performance of our asset classes, apart from inflation. And, moreover, the change in prices happens slowly, and we can clearly observe how many of these funds, sooner or later, see an improvement in performance towards the end of our series, to mark the approach of an inflationary time.
Let us compare with the performance of three benchmarks: the S&P 500 (^GSPC), the 60/40 portfolio (BIGPX) and the iShares treasury bond ETF (GOVT).
Although the difference between the 60/40 portfolio and the S&P 500 is not materially big, we can clearly see how US Treasuries performed differently over time. Most importantly, as we are approaching inflationary times, the spread between the two indices reaches a relative maximum (from this chart, it is wider than during Covid).
Please find below a summary of the performance of the ETFs and benchmarks (Trend Following in blue, TIPS in red, Real Returns in green, Asset Class Hedging in orange, Benchmark in black):
This is a lot of numbers, so let’s try to make them a bit more digestible. In terms of absolute returns, during non-inflationary times, no ETF outperforms equities or 60/40. This is very clear: the best ETFs are either TIPS (in non-inflationary times, it sounds like a surprise) and DBMF, a trend-following strategy with a relatively higher risk appetite than WTMF.
However, it is also true that the volatility of the S&P 500 is higher. With the exception of SCHH (REITs), no ETF is as risky (or riskier) than Equities. Please keep in mind that we are not comparing apples with apples: different asset classes and strategies, investing in a variety of instruments, perform differently from equities or the 60/40 portfolio, and this is understood. We need to diversify our investments and include a variety of asset classes, so we do not expect the S&P 500 to necessarily underperform them. The only target here is to understand how risky and how rewarding these ETFs are in different regimes.
That said, we can directly jump to the Sharpe Ratio: various instruments seem to outperform the index, and they are the TIPS group and the 60/40 portfolio. VTAPX is outstanding during this time, and we need to clarify that it is a bit more specific than the other TIPS ETFs: it invests in short-term inflation-protected securities, thus it narrows down the universe of investable TIPS by construction, a remarkable difference when inflation is low, apparently. However, its return is much lower than peers in the group.
Drawdowns are relatively attractive for TIPS and Trend Following. Commodities and REITs perform pretty much like Equities, but with a worse Sharpe Ratio and return. The two Real Returns strategies differ considerably, since RLY is much more risk-seeking than CPI. And drawdowns are obviously reflecting this fundamental difference, too.
Finally, in terms of beta, it is very interesting to see how TIPS really help in diversifying our portfolio. DBMF is also very good, and it delivers higher returns. REITs and Commodities seem to follow Equities quite substantially, underperforming considerably on all metrics.
In conclusion, for lower risk tolerances, TIPS seem to be an optimal solution, especially VTAPX. During non-inflationary times, it appears they still deliver superior risk-adjusted returns and considerable diversification benefits.
When inflation is high
The performance of our strategies during non-inflationary times suggested that some of these might truly underperform, if macro conditions do not favor them. Although our findings might still be coincidental, as many factors can contribute to the success of an ETF, the underperformance of Real Returns and most importantly Asset Class Hedging suggest that such investments will not be rewarding if we hold them in our portfolio at the wrong time.
From the above chart, however, we already notice that what did not work with low inflation might work during high inflation. DBC (the orange line) suggests Commodities actually do work during peaking inflation, and other ETFs, such as RLY and DBMF, seem to deliver better than in the previous case.
Now let’s focus on the strategy groups:
TIPS underperform significantly, with the exception of VTAPX. The picture is somehow expressing how high inflation is not the only factor we can trust, as rates are probably contributing to the underperformance of Fixed Income securities, combined with a variety of other possibilities.
Trend Following, in this case, seems to work well as a hedge for some time, but from the end of 2022 the underperformance is considerable, in particular for DBMF. WTMF, the low-risk version, seems to shine approximately when DBMF falls (with a lag of some months).
In Real Returns, CPI seems to fail to hedge our inflation risk. And REITs are also not performing as intended, after 2021: while many claim that Real Estate functions as a hedge against inflation, we are observing how inefficient it is in this example, maybe due to its particular implementation.
How did our benchmarks perform in the same period?
As many might have already been hearing for a while, the surprising spikes in bond volatilities and the correlation to equities led these indices to underperform. In particular, this seems to damage the 60/40 portfolio quite substantially, if we compare it with the S&P 500, and the spread is much wider here than in a low inflation regime.
Let us now have a look at the statistics of the examined products:
It is clear that Equities underperformed, but the 60/40 portfolio (BIGPX) and Treasuries (GOVT) did even worse. The drawdown is lower than during Covid, but that is a very unpredictable event, whereas in this case drawdown is caused by a prolonged period of underperformance.
The best risk-adjusted returns, but also absolute returns, are found in commodities (DBC). In this case, the risk appetite of the fund rewards investors by providing them with superior performance over inflationary times.
But if we have to select two securities to include in our portfolio over good and bad times, the striking consistency of VTAPX and DBMF makes them the global winners of our exercise. Short-term inflation-linked securities and the trend-following expression in DBMF provide investors with an extremely convenient level of risk-adjusted returns and, depending on your personal risk appetite, you might want to favor VTAPX (lower risk) or DBMF (higher risk). Diversification benefits are noticeable, provided that the two assets have a correlation close to zero, and drawdowns are under control (but VTAPX keeps them extremely low, relative to its return).
Dulcis in fundo…
It was not a long time ago that many were exploring additional possibilities to hedge inflation. Some even considered Bitcoin as an hedge (but 2022 performance let us think that this is definitely not the case).
But many might remember this Bloomberg chart from last year:
We now need to update it! How did Bitcoin and avocados do against inflation? We will consider the price on Yahoo for Bitcoin against USD and Mission Produce Inc. (AVO) stock, a global leader in the sector. For this study, the non-inflationary times start in October 2020 (due to AVO stock price data availability). Here are the charts with our benchmarks:
The risk appetite of the two seems quite different! Let's have a look at the tables.
Low inflation:
High inflation:
(Please note that the numerical difference from the previous table for our benchmarks is due to the differing availability of data for AVO and BTC).
Well, this thesis has also to be demystified. Of course, we are not truly measuring the performance of avocados’ prices but the stock of a company producing them. Still, it seems like its beta is not really allowing us to consider it a hedge. Thus, before trusting what you read on the internet, be careful about the way you implement it, and always verify these findings before moving on with your portfolio and investments.
Final considerations
In order to hedge against inflation, we must always consider all existing conditions. Interest rate hikes, different types of CPI, and combinations of ETFs in our portfolio are only some of the factors that we should consider. From our brief analysis, it seems that some TIPS and Trend Following strategies might help in hedging inflation risk, while being part of our portfolio in deflationary times as well. This helps us as we do not have to time inflation, but we can keep them as part of our portfolio even when it goes away.
Update on strategies
I removed ChatGPT, as its performance was poor, and maintaining it would be a matter of deep study that goes beyond the scope of this series. We can also keep under our monitor the two inflation hedges now, namely VTAPX and DBMF.
From this month, I’ll also highlight the increase or decrease relative to last time’s print in green or red.
Updates as of June 13, 2023:
Trading strategy is based on the author's views and analysis as of the date of first publication. From time to time the author's views may change due to new information or evolving market conditions. Any major updates to the author's views will be published separately in the author's weekly commentary or a new deep dive.
This content is for educational purposes only and is NOT financial advice. Before acting on any information you must consult with your financial advisor.