With the unemployment rate pushing 10% and the housing market still hobbled, inflation seems more like a distant memory than a near-term possibility. But as signs of economic growth slowly surface, interest is perking up for investments that could do well in an environment of rising prices or increasing interest rates.
According to a recent Wall Street Journal poll, economists expect U.S. GDP growth to rise to 3% by the end of the year, a slight increase from 2010. Despite this benign outlook, government measures to stimulate the economy and boost growth continue to raise concerns about inflation, while demand from emerging market economies provides a solid backwind for commodity prices.
"We believe that financial advisors are showing interest in commodity ETFs and other products because they have historically done well in an inflationary environment," says Bryon Lake, senior product strategy manager at Invesco PowerShares. "We think this will be an important issue for 2011 and going forward."
A number of ETF options stand to benefit if a reflation scenario begins to unfold this year.
TIPS. The securities behind TIPS ETFs have a fixed coupon. However, interest payments fluctuate over the life of the bond along with its inflation-adjusted principal value. Bond prices also reflect changes in marketplace interest rates and demand.
Although they are considered inflation-linked securities, their returns can exceed or fall short of their inflation bogey, the Consumer Price Index. And they can underperform traditional Treasury securities or lose value when interest rates rise sharply or demand drops.
In 2008, TIPS underperformed traditional Treasurys when investors fled to the perceived safety of the latter investment in 2008, according to a Vanguard study. In 2005 and 2006, rising real interest rates produced negative inflation-adjusted returns. But in seven years over the last decade, TIPS' returns exceeded inflation.
There are half a dozen TIPS ETFs on the market from Barclays, PIMCO, State Street Global Advisors and Schwab. Even in this seemingly homogenous group, performance can vary with index construction and other factors. The iShares Barclays TIPS Bond Fund (TIP), with $20 billion in assets, represents the bulk of the TIPS ETF market. With an effective duration of 4.8 years, the fund is somewhat less sensitive to interest rate fluctuations than PIMCO's 15+ Year U.S. TIPS Index Fund (LTPZ), which has an effective duration of 7.4 years.
The difference can have a big impact on returns. From the beginning of the year until December 20, 2010, a time of declining rates and rising bond prices, the longer duration PIMCO fund had a total return of 8.23%, compared with 5.68% for the Barclays offering. Of course, the leaders could change if interest rates go up.
The latest twist in TIPS ETFs is funds with shorter durations, which are designed to derive a greater portion of their returns from inflation-adjusted income rather than changes to principal. Because of their shorter durations, they are less sensitive to fluctuations in marketplace interest rates than their longer-term cousins. Launched in December 2010, the iShares Barclays 0-5 Year TIPS Bond Fund (STIP) has an effective duration of 1.7 years while another short-term offering, the PIMCO 1-5 Year U.S. TIPS Index ETF (STPZ), goes out to 1.5 years.