IInvestors should consider an updated inflation hedge exchange-traded fund strategy that may help better weather current inflationary pressures.
In the recent webcast, Inflation Strategies: How to Survive Extraordinary Times, James Davolos, Portfolio Manager and Research Analyst, Horizon Kinetics, described the shifts in fundamentals that contributed to the high inflationary headwinds we face today. .
Specifically, Davolos noted that the US money supply has increased by about 40% since the end of 2019. Federal debt, the increase in which is linked to money printing, now represents the highest proportion of GDP that ever was. About 13% of all dollars ever created in the history of the United States of America were created in the last 12 months.
“If the economy cannot grow enough to allow the debt-to-GDP ratio to gradually come down to a sustainable level, the government’s only politically realistic option – a solution outdated – is to continue printing more ‘money,” Davolos said.
Davolos also added that the benign inflation environment of the past decades has been partly a function of the significant decline in commodity prices, which is highly unlikely to persist. It is becoming increasingly difficult to produce the raw materials needed to sustain global growth at a high standard of living. In addition, fiscal spending will likely put additional pressure on key commodity markets.
Investors also face challenges when choosing the right assets to invest in under these conditions.
“Cash and bonds are extraordinarily overvalued, at near-zero yields that are outpaced by the current rate of inflation; equities, by some measures, are overvalued beyond historical precedents,” Davolos said.
Robert Sechan, CEO, Managing Partner, Co-Founder of NewEdge Wealth, highlighted some of the shortcomings of traditional inflation hedging investing. For example, Treasury Inflation Protected Securities, or TIPS, have been a popular option for fixed income investors. However, he explained that inflation expectations and long-term interest rates are highly correlated; outsized movements in interest rates relative to inflation can therefore hamper TIPS bond returns. The price of TIPS will only rise in the meantime if inflation expectations rise relative to the 10-year yield.
Growth stocks, which have been on a multi-year bull run, are also under pressure amid looming rising interest rates. Strategists have warned that growth stocks have near infinite duration or very high P/E levels, so they generally have a negative correlation with interest rates.
Alternatively, Davolos highlighted the benefits of Horizon Kinetics Inflation Beneficiaries ETF (INFL), an actively managed ETF seeking long-term capital growth in real (inflation-adjusted) terms. It aims to achieve its investment objective by investing primarily in domestic and foreign equity securities of companies which are expected to benefit, directly or indirectly, from rising prices of real assets (i.e. assets whose value comes primarily from physical properties such as commodities) such as those whose revenues are expected to rise with inflation without a corresponding increase in expenses.
“We consider companies that exhibit scalable and economically resilient business models,” Davolos said. “Many offer exposure to sustainable assets through small capitalization business models.”
Prospective investors should note that INFL is not a binary “bet” on inflation. The fund focuses on companies that have the potential to generate high cash flows under moderate inflation scenarios, but which are significantly higher under certain rising inflation conditions. This portfolio is designed to benefit from inflation (ie to appreciate), not just to maintain its value in an inflationary environment.
INFL’s strategy focuses on sustainable assets with a low-capital approach. The low capital business model requires less working capital and debt while achieving higher returns on capital. This facilitates higher capitalization of capital over full business cycles. These low-cap business models include areas such as transaction facilitators, royalty and streaming companies, data and research companies, timber, agriculture, real estate, and infrastructure managers.
“We believe they improve the commercial quality of a portfolio and reduce cyclicality – it’s not a ‘bet’ on inflation,” Davolos said.
Financial advisors interested in learning more about inflation hedging strategies can watch the webcast here on demand.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.