Inflation - What’s an investor to do?

As CPI and inflation continue their upward march despite all the forecasts that the post Covid inflation is transitory (which itself we find ironic given all inflation is transitory), what’s an investor to do?

 
 

Above: Consumer Price Index (CPI) Year over Year % Change


Gold has struggled for a year now, energy stocks sold off almost 12% in July, and rates have dropped for the last three months despite record increases in CPI and other inflation metrics.

For a detailed perspective on improving portfolio returns, we recommend reviewing our March 2021 paper “Positioning for the 2020s Commodity Bull Market – Select Your Exposure Wisely”.

However, this month’s blog provides a brief update by looking at the performance of ten ETFs popular for inflation hedging:

  • Resource / Commodity Equity ETFs

    1. NANR - SPDR S&P North American Natural Resources ETF

    2. XLE - Energy Select Sector SPDR Fund

    3. GDX - VanEck Vectors Gold Miners ETF

  • Passive Broad Commodity ETFs

    1. PDBC - Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (largest)

    2. GSG - iShares S&P GSCI Commodity-Indexed Trust (tracks SP GSCI com. index)

    3. DJP - iPath® Bloomberg Commodity Index Total Return ETN (tracks BCOM com. index)

  • Popular Inflation Themed ETFs

    1. TIP - iShares TIPS Bond ETF

    2. IVOL - The Quadratic Interest Rate Volatility and Inflation Hedge ETF

    3. GLD - SPDR Gold Shares ETF

  • Tactical Balanced Commodity ETFs

    1. COM - Direxion Auspice Broad Commodity Strategy ETF

While the above covers some of the most popular inflation sensitive ETFs, the above list is by no means comprehensive. There are many leveraged ETFs, as well as single commodities and stocks that may perform strong at times.

The January 2020 – July 2021 period analyzed below covers both the selloff and recovery surrounding Covid. There would be ETFs that outperformed in the initial selloff, and others that outperformed in the recovery. Timing these, as we know, is difficult, and we recommend investors look for portfolio solutions that can be held for long periods.

Inflation ETF 2021 performance commodities IVOL TIP PDBC.png

When we consider individual strategies or ETFs to add to a portfolio, we are generally most interested in the standalone returns and correlation — these are most impactful to the broader portfolio. While the Sharpe for an individual strategy or ETF can be interesting, Sharpe is truly only important in the context of portfolio construction when correlation is also considered(1). Accordingly, the above individual ETFs are ranked by cumulative returns over the period.

What does this mean for your portfolio?

Consider a 20% allocation of each to a 60/40 portfolio. The 60/40 portfolio performed quite well over this period with bonds offsetting some of the equity losses in Q1 2020 and providing much needed diversification. In turn, equities then rebounded spectacularly with one of the biggest rallies in our generation.  The classic 60/40 portfolio generated a Sharpe of 1.02 - a high bar to beat.   And that’s precisely what we are focused on when analyzing portfolio combinations - its portfolio Sharpe.

The below portfolios accordingly are ranked by Sharpe.

60 40 traditional portfolio plus inflation ETFs alternatives.png

Key Considerations:

  1. Correlation is key. All returns are not equal, diversification is the only free lunch. The combinations with COM, TIP, and GLD comes out on top, each ETF with ACWI correlations < 0.3

  2. What’s your risk threshold? How big of a drawdown can you handle? The addition of NANR to the 60/40 portfolio produced the strongest cumulative returns but with significantly more risk to the portfolio - the Sharpe decreased significantly and the max portfolio drawdown was the second largest. There are many other portfolio combinations that improve returns and lower risk.

Other Considerations:

  1. Particularly here in Canada, we tend to think our portfolios have exposure to inflation given the commodity intensity of our economy. While true in some respects, as demonstrated above, the portfolio benefits can be quite low. We always encourage investors to consider each investment in the broader context of your portfolio.

  2. The above analysis covers a key period in which global markets experienced both a notable selloff and a dramatic recovery. That said, the period is less than two years, and we would recommend a longer term analysis, such as the article referenced above.

  3. The above analysis also includes a period in which stocks (MSCI ACWI) had a historically low 0.16 correlation to bonds (AGG). If this relationship were to change and become more positive, as experienced in other inflationary environments(2), the diversification benefits of the 60/40 portfolio will become much lower.

About COM:

The COM ETF’s objective is to replicate the performance of the Auspice Broad Commodity Index, an active long/flat diversified commodity index that has been published by the NYSE since 2010. COM is the only 5-star ranked Morningstar commodity ETF.

For institutional investors, the Auspice Broad Commodity Index, the underlying index to COM, is also available via managed account that has averaged under 5% margin.

For more information please email info@auspicecapital.com

 

References

1.    https://www.institutionalinvestor.com/article/b1p62z599ns4pd/The-Sharpe-Ratio-Broke-Investors-Brains

2.    https://www.cmegroup.com/education/featured-reports/what-higher-inflation-might-really-mean-for-investors.html#

 

Disclaimer below 

IMPORTANT DISCLAIMERS AND NOTES

The Auspice Broad Commodity strategy combines opportunistic commodity exposure with capital preservation. Returns for Auspice Broad Commodity Excess Return Index or “ABCERI” represent returns calculated and published by the NYSE. ABCERI index calculated and published by NYSE since Sep. 2010. The index does not have commissions, management/incentive fees or operating expenses.

Futures trading is speculative and is not suitable for all customers. Past results are not necessarily indicative of future results. This document is for information purposes only and should not be construed as an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice. Auspice Capital Advisors Ltd. makes no representation or warranty relating to any information herein, which is derived from independent sources. No securities regulatory authority has expressed an opinion about the securities offered herein and it is an offence to claim otherwise.

QUALIFIED INVESTORS

For U.S. investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, is only available to Qualified Eligible Persons “QEP’s” as defined by CFTC Regulation 4.7.

For Canadian investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, or Auspice One Fund “AOF”, is only available to “Accredited Investors” as defined by CSA NI 45-106.