In the wake of the pandemic, many institutional investors think that significant sticky inflation – which some are experiencing for the first time – will be a transitory challenge. According to an analysis from BlackRock Investment Institute, however, heightened inflation will be a more sustained factor, rising to perhaps 5% in the next four months before settling to just under 3% through the end of 2022 (and remember that it remained under 2% for most of the last two decades).1 Why? According to BlackRock, none of the inflation’s driving factors – including supply chain disruption, semiconductor shortages, tight labor, and rising shelter costs – are going to resolve quickly, and we can expect them to contribute to higher inflation over the coming year.2
Of all the financial tools that investors can utilize to strategically position their portfolios for sustained inflation, using ETFs can offer several advantages. This article will explore these potential benefits and offer insights to institutional investors looking to best minimize investment risk and capture upside opportunities in the current inflationary climate.
ETFs offer three key advantages
ETFs have changed the ways investors can react to almost any market scenario. When Institutional Investor conducted a global survey of 766 institutional investment decision makers in Q3 2020, 70% said they had used ETFs to rebalance during pandemic-related volatility – making ETFs the most popular financial tool for this purpose.3 Further, 68% of institutional investors expected continued heightened volatility over the next 18 months (through early 2022) and 65% said they plan to increase use of ETFs in the same time period, outpacing derivatives (62%), mutual funds (59%), and any other instrument.4
The features that have fueled ETFs growing popularity for the last several years are closely aligned with the three key advantages they offer over choosing individuals bonds or stocks for positioning a portfolio against inflation (among other strategic purposes): “Diversification, cost effectiveness and liquidity,” says Gargi Chaudhuri, Head of iShares Americas Investment Strategy at BlackRock.
“For fixed income, if you’re looking at just picking bonds versus accessing ETFs that offer exposure to a basket of securities, the diversification that an ETF offers is a strong advantage,” says Chaudhuri. “And the same obviously goes for equities, where an ETF gives exposure to many different companies rather than having you decide which will have the most inflation sensitivity or inflation hedge. Overall, investors should look at every segment of the market and determine which ETFs can help them guard against sticky inflation.”
Regarding costs, ETFs can also deliver savings when compared to actively managed funds. “Especially in today’s low yield environment and low return environment, you want to gravitate towards exposures that give you a lower cost opportunity,” says Chaudhuri.
Thirdly, the liquidity that ETFs bring enable investors to trade in and out of positions quickly. “Having that underlying liquidity at a lower cost is extremely meaningful in today’s fast-moving, inflationary framework, when stories can change quickly,” says Chaudhuri. “For example, there’s news on supply chain every day, and [Consumer Price Index] trends are significantly far from economists’ expectations. When there’s elevated volatility around inflation, having access to that liquidity and transparency in the ETF market is highly important.”
7 iShares ETFs to consider now…
No one investment vehicle alone can fully position a portfolio against inflation. Hedging strategies often include a combination of investment vehicles – including ETFs – across asset classes. In choosing different ETFs to build protection across segments and sectors, Chaudhuri notes that many institutions are using these specific seven iShares ETFs as part of their inflationary hedging strategies.
Fixed income
The iShares TIPS Bond ETF (TIP) offers exposure to the full index of Treasury-protected inflation securities, or TIPS, which are government bonds that rise in value with inflation and typically have a duration of five to eight years. “TIPS are the asset that investors mostly use to position against inflation,” says Chaudhuri. “As headline CPI goes up, you’ll accrue more of an advantage by owning TIPS versus nominal bonds.”
The iShares 0-5 Year TIPS Bond ETF (STIP) offers exposure to the zero-to-five-year sector of inflation-protected bonds. “It focuses more on the front end of the curve, so it suits investors who believe inflation will be with us for a little shorter period of time than others are predicting,” says Chaudhuri.
The iShares Fallen Angels USD Bond ETF (FALN) tracks an index of high-yield U.S. corporate bonds that were previously rated investment grade and can be held to seek income. “After TIP and STIP, looking at FALN – which is a high-yield ETF given its exposure to energy – can bode well for investors looking within the fixed-income sector for an inflation hedge.”
Equities
I have been a fixed income investor my whole life, but I would say that equities are actually your best inflation hedge,” says Chaudhuri. The sectors that have the highest inflation sensitivity are in energies, financials, and small caps, she notes. The iShares U.S. Oil & Gas Exploration & Production ETF (IEO) and iShares US Oil Equipment & Services ETF (IEZ) are energy-related, and the iShares U.S. Financials ETF (IYF) offers diversified exposure to the financial sector.
Commodities
“Lastly, you need to think about the commodity markets – not just for inflation sensitivity, but also because prices in every sector of commodities are moving up significantly and each of the stories are different,” Chaudhuri explains. “The iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) gives you exposure to a basket of commodities to hedge your inflation exposure.”
…and 4 to consider when inflation declines
When inflation begins to subside, institutions will naturally want to pivot their positions quickly to capture new upside and minimize opportunity cost. “Right now, we believe we’re in an inflationary environment where you want to allocate to ETFs that help guard against inflation, but once you believe inflation is no longer an issue, you’ll want to allocate to those areas of the market that do well when inflation is slowing down,” says Chaudhuri. “And what has tended to do well when growth and inflation are slowing down is duration.”
For example, when analysts at institutional investors believe inflation concerns have waned, they may consider increasing their allocations to ETFs with similar characteristics to these four iShares vehicles:
Fixed income
By offering exposure to U.S. investment-grade bonds, long-term U.S. Treasury bonds, and high-quality corporate bonds, respectively, these three iShares ETFs “can offer duration protection that’s useful in an environment where inflation is slowing down or there’s a fear that interest rates are going to move lower,” Chaudhuri says. These three iShares vehicles are also known as the iShares Core U.S. Aggregate Bond ETF (AGG), iShares Exponential Technologies ETF (XT), and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
Equities
“As with securities, look for long-duration equities in growth sectors of the market to do well as inflation wanes,” says Chaudhuri. “Thematics, technology, and anything related to robotics could do well because of the length of the cash flow,” she adds, noting that the iShares Exponential Technologies ETF (XT) is a strong example of an iShares vehicle that offers exposure to global tech companies with a growth bias.
During volatility, speed and agility are vital
While institutional investors have long been increasing their allocations to ETFs, many are likely upping them even more steeply than planned to construct new hedges against inflation – and this strategy makes sense for the several aforementioned reasons. But it’s worth emphasizing that in volatile, inflationary environments that require quick responses to changes, the speed and agility ETFs offer can be the most important advantages for investors.
“Even if you already have a significant chunk of your portfolio allocated to inflation hedges, you may realize at any given moment that it’s not enough,” says Chaudhuri. “At that point, you can use ETFs to quickly add to your allocations in a liquid, cost-efficient, tax-efficient manner. And as inflation volatility picks up, having a financial instrument that allows this kind of flexibility and access will be more important than ever before – and the specific exposures within the iShares ETFs can be particularly useful to help protect your portfolio.”
Learn more about using ETFs to position for sticky inflation.
1 BlackRock Investment Institute, Federal Reserve Board, U.S. Bureau of Labor Statistics, Bloomberg, with data from Haver Analytics, December 2021. https://www.blackrock.com/americas-offshore/en/insights/blackrock-investment-institute/outlook#global-outlook
2 The Long and Short of Shortages. BlackRock, October 2021. https://www.ishares.com/us/insights/the-long-and-short-of-shortages
3 Managing Market Volatility in 2021: What institutional investors did in 2020 – and what they learned. Institutional Investor, January 2021. https://www.institutionalinvestor.com/media/documents/institutional-investor/tl/managing-market-volatility-in-2021/Global%20Report_Chapter%201_Standalone_STAMPED.pdf
4 Managing Market Volatility in 2021, Institutional Investor, January 2021.
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