Can index funds and ETFs protect against inflation?

When inflation and uncertainty are running high, certain assets and parts of the market tend to hold their value more robustly.

The latest consumer prices index shows prices up by 10.1% over the year to July, and with the Bank of England anticipating a high of 13.3% in October, rising prices are preoccupying everyone from the government downwards.

But inflation is not only wreaking havoc on household budgets; it’s also undermining private investors’ portfolios.

However, as always, there are certain assets and parts of the market that tend to hold their value more robustly in the face of rampant inflation. Either active or passive funds can offer protection, but there’s arguably a case to make for protecting against rising prices by focusing on those more resilient asset classes through exchange-traded funds (ETFs) and passive funds, rather than paying more for the stock-picking expertise of an active manager.

• Explore: ii Super 60 Investments |  Transferring an Investment Account | Free regular investing

As Peter Sleep, senior investment manager at 7IM, points out: “The advantage of passive is that it is a lot cheaper, and there are no issues of the portfolio manager leaving or changing his or her style.  

“With passive you will always be in line with the market; with an active manager you might beat the market, or you might fall short. Some people like the option of added value from active managers, while others like the certainty and low cost of passive.”

Inflation-linked bonds have not escaped the sell-off

So, where should investors inclined to the passive approach be looking in their search for an inflation hedge?

Historically, index-linked bonds and UK government bonds (gilts) have been an obvious choice, but Sleep warns that while the inflation-linked element of these bonds have risen, bond prices in general have sold off heavily this year.

“Inflation-linked bond funds are really not the thing to do at the moment,” he says.

One example that demonstrates how volatile such funds have been this year is Vanguard UK Inflation Linked Gilt Index Fund. The fund is down 17.4% year-to-date. The average Investment Association (IA) UK Index Linked Gilt fund, both active and passive, has lost 18.1%, figures from FE Fundinfo show.

An inflation hedge that’s working

One slightly less volatile alternative in the fixed income arena, according to L&G Investment Management’s head of ETFs, Howie Li, are broad commodities funds. Such funds have been benefiting from the current global geopolitical situation and the macroeconomic pressures at work. “It’s partly an inflation hedge, but partly also to take advantage of this opportunity for commodities,” he explains.

• Don’t be shy, ask ii….why is this inflation-linked bond fund losing money?
• Top 10 tips and tricks to inflation-proof your portfolio
• Consumer staples shine as inflation soars – but can the boom last?

The obvious choices are energy-focused ETFs benefiting from the massive price hikes hitting consumers and businesses. However, Li points also to grain and livestock prices as beneficiaries, not just of the Ukraine situation that is disrupting global grain supplies, but also of the impact of climate change and the trend towards deglobalisation, which is pushing countries towards greater self-sufficiency.

“I think commodities will continue to be a very strong area,” he says. Commodity markets “are probably best referenced by the Bloomberg commodity benchmark series of indices” and a number of ETFs follow them. 

L&G’s own offerings include an L&G All Commodities ETF (LSE:BCOG) and its L&G Longer Dated All Commodities ETF (LSE:COMF) sibling. Li explains that the latter holds longer-dated commodities contracts, which makes it less susceptible to near-term market volatility.

He also highlights a less conventional approach to commodities ETF construction, which can enhance investment potential. “There are a number of ways to invest in commodities more efficiently and take a much more active approach, but still apply that approach systematically,” he adds.

The L&G Multi-Strategy Enhanced Commodities ETF (LSE:ENCO), for instance, identifies the most efficient commodity groups from a futures perspective, and also use other parameters such as seasonality.

In interactive investor’s Super 60 list is WisdomTree Enhanced Commodity ETF (LSE:WCOB). It offers investors a broad and diversified commodity exposure, covering major commodity sectors such as industrial metals, precious metals, energy and agriculture.

Sleep picks out gold ETFs as a commodity option. “Gold is primarily a hedge against human stupidity rather than inflation,” he says. “It’s worked since the 1970s against inflation, but it’s not a one-for-one relationship.”

Equities best way to beat inflation

Historically, the best long-term hedge against inflation is equities, because they represent real businesses making and doing real things, with prices that can adjust to align with inflation. But the short-term volatility of equities means it’s important to keep a well-diversified portfolio.

Moreover, equities come in many forms, and some provide a more resilient defence than others in the face of rising prices. Reliable dividends are a valuable bolster to total returns, but companies in some sectors - for instance, airlines, car manufacturers or fashion retailers – may struggle to keep paying out to shareholders as their materials, fuel and labour costs rise and consumer spending falls.

One approach is to use ETFs weighted to the historically reliable big dividend paying companies, which in the UK have tended to cluster in the FTSE 100. Sleep suggests that a straightforward tracker following the blue-chip index would be “not a bad inflation hedge”.

• How to play the market rotation: fund, trust and ETF ideas 
• Fund Finder: value versus growth investing

The Vanguard FTSE UK Equity Income Index, a member of interactive investor’s Super 60, has a dividend yield of 5.4%. Among its biggest constituents are oil and commodity companies, which are currently on a roll in the face of geopolitical events and supply disruption, as well as banks (which do well in inflationary times when interest rates are rising).

In addition, says Sleep, the FTSE’s weighting towards the asset-rich value stocks that have strongly outperformed the wider market this year stands it in good stead compared with other more growth-focused indices such as the US Nasdaq.

Look to dividend strategies

Dimitar Boyadzhiev, a senior analyst at Morningstar, takes a different tack, pointing investors anxious about inflation towards the range of ‘strategic beta’ equity ETFs available. These ETFs screen a market for certain factors or characteristics.

Both Boyadzhiev and Li also see dividends as a useful inflation hedge, but they prefer dividend-oriented strategic beta ETFs as a more targeted approach than a straight FTSE 100 tracker.

These favour larger, high-quality companies with certain fundamentals – stable and growing cash flows, lower debt, competitive business models – that are likely to make them more reliable dividend payers and better poised to outperform as interest rates rise.

Boyadzhiev points out: “A global portfolio of dividend stocks with these favourable characteristics can be easily accessed with a single product, such as the Fidelity Global Quality Income ETF (LSE:FGQD). The fund offers investors a strategy that achieves a good balance between quality and dividend yield.”

However, Sleep looks on the quality factor as something of a double-edged sword. “Quality has some defensive characteristics to it, in that you’re buying consumer stocks with strong brands that are able to pass on price rises. But they tend to be quite highly priced, they don’t have much in the way of real assets underpinning them, and they can be quite sensitive to interest rate rises, as we’ve seen this year. I prefer high dividend-paying stocks over quality stocks at present.”

Value style favoured over growth

Strategic beta ETFs can also be used for more focused exposure to value stocks, which typically have strong earnings yields relative to their stock price. Indeed, says Boyadzhiev, rising inflation tends to be one of the catalysts for “factor rotation”, as growth stocks are typically more likely to have debt and therefore more sensitive to interest rate hikes.

• The great investment strategies: value investing
• Five tips to cope in a bear market 

To put that into context he gives a comparison: “A growth stock strategy as represented by the MSCI World Growth index has underperformed relative to the broad MSCI World this year, whereas a value-based strategy following the MSCI World Value index has outperformed it by the same measure over that time.”

One option in that context is the iShares Edge MSCI World Value ETF (LSE:IWVL).

Finally, Li suggests another thematic approach likely to prove robust as prices rise. “We like high-growth industries specifically aimed at enabling new disruptive technologies such as artificial intelligence, battery storage or  cybersecurity to become the key sectors of tomorrow, as the transition to green energy and a more technologically enabled world takes place,” he says.

He argues that the green energy theme in particular has “exceptional pricing power”, which means that rising prices can easily be passed on to consumers when inflation is prevalent.  

L&G runs a wide range of targeted ETFs covering forward-looking themes including artificial intelligence, green energy, clean water, battery storage and digital payments among others.

Overall, though, when inflation and uncertainty are running high, the best portfolio hedge is likely to involve a spread of different assets and approaches.