ETFs can help eurozone investors cater for their inflation protection needs. However, in this article we will argue the case that for a large number of eurozone investors, an effective inflation hedging strategy will need to be undertaken with a holistic approach, combining a number of funds and asset classes rather than solely relying on the assumed merits of eurozone inflation-protection government bond ETFs.
For much of the economic crisis the eurozone experienced a distinct lack of inflationary pressures. However, the rise in international commodities prices of late 2010 and early 2011 has pushed headline HICP above the European Central Bank’s (ECB) 2.0% definition of price stability. In its March policy meeting, the ECB warned markets of a possible interest rate rise in April, well
Despite the increased hawkishness in ECB rhetoric, at this stage it seems likely that monetary tightening will be limited and spaced out in time. It should perhaps be best understood as a warning call to avoid second-round (e.g. wage-led) sticky price pressures developing, particularly in growing economies like Germany, where unit labour costs are already on an upside trend. For the fact remains that other economic variables potentially feeding eurozone inflation remain very subdued. For example, money supply growth is well below its long-term historical average. Also, the level of spare capacity in the peripheral economies remains high, while budget consolidation measures implemented in most eurozone countries should be expected to have a lasting dampening effect on private consumption growth. Still, understandably, the investor community may be finding it difficult to take a measured approach to future inflation risks when they see prices rising across the board in real time. As a result, the search for protection against inflation has become a priority.
There is no shortage of ETFs giving investors exposure to the performance of the market of Eurozone government inflation-linked bonds. As of mid-March 2010 we counted six funds from the major providers with combined assets under management close to EUR 1.7bn and with annual TERs ranging from 0.16% to 0.28%.
As is commonplace in the ETF world, we find a variety of indices (e.g. Barclays Capital, iBoxx, EuroMTS) used by providers to track market performance. Each of these indices will follow different construction rules which will obviously impact their performance and thus ETP returns. However, while important, this is not the main problem faced by Eurozone investors seeking adequate inflation protection for their portfolios. Indeed, in our view, the two key problems are geographical bias and lack of maturity segmentation.
The Geographical Bias Problem
The Eurozone government inflation-linked market is a Franco-Italian-German affair, with a tiny splash of Greece thrown in for good measure. The origins of this market are traced back to France, first with products linked to its domestic CPI and since 2001 also to eurozone HICP (ex. tobacco prices). In the mid-to-late part of last decade we saw the addition of Italy and then Germany (note – Greece’s incursion can be best summed up as anecdotical), both exclusively issuing bonds linked to eurozone HICP (ex. tobacco prices). As of now, the eurozone government inflation-linked bond market stands second in terms of outstanding volumes and turnover to the US, with annual sales representing around 10-12% of the eurozone total government bond issuance. On account of its long history, as well as a regular issuance cycle, French linkers are the Eurozone inflation-linked benchmark of reference.
The problem for some eurozone investors is not the restricted number of issuing countries, but rather the fact that stocking up on protection against inflation as measured by eurozone HICP (ex. tobacco prices) may leave you only partially protected. As the accompanying graphic shows, in 2000-2010 average annual eurozone inflation (ex. tobacco prices) stood just below 2.0%. During the same period only Germany, France, Finland and Austria posted average national rates below the eurozone, while the remaining countries sustained a positive price differential. As a result, investors with portfolios biased to these latter countries would have had to seek additional inflation protection beyond that offered by a eurozone government inflation-linked bond or ETPs tracking them.
Lack of Maturity Segmentation
The second main shortcoming we have highlighted is the lack of maturity segmentation. In contrast to the improvements on the offering of ETFs tracking the market of eurozone conventional government bonds, ETFs tracking inflation-linked bonds are only limited to those covering the whole maturity spectrum. The relative small size of the market and the long-dated bias of inflation-linked government issuance are the two key reasons precluding ETF and index providers to offer maturity-segmented products for this particular asset class. However, from the investor’s point of view this makes the business of setting inflation hedging strategies to specific time horizons a difficult enterprise.
As mentioned, the bulk of new government inflation-linked bond issuance tends to be long-dated to cater for the specific business needs of the key institutional buyers of these products, namely pension funds and insurance companies. As a result, eurozone inflation-linked ETFs track indices with a fairly high average maturity and thus a fairly high average duration. This is not optimal in a situation when for example one wants to set up a hedging strategy timed to the short-term. More so, it is less than optimal at a time when monetary policy signals argue for an overall shortening of duration of fixed income portfolios. There is definitively plenty of room for improvement on this front, both for index and ETF providers.
Pick and Mix to Build Full Protection
On account of the shortcomings cited it would seem clear that for some eurozone investors inflation-linked ETFs would be best used as a building block of a comprehensive hedging strategy rather than as a sole weapon.
The inflation protection properties of some commodities, particularly precious metals, are well documented, and so for some investors, gaining additional protection via the relevant ETCs could be a possibility. However, it is important to note that ETCs, particularly those built using futures contracts, may not be suitable for everybody.
The same goes for ETFs built and marketed as tactical investment tools and which allow investors to take bets on the future path of inflation expectations. For example, the db x-trackers Inflation Swap 5 year TR Index ETF (DX20) would fall into this category.
Equity ETFs can of course also be part of an inflation protection strategy. For instance, overweighting exposure to market segments likely to benefit from the rise in consumer prices (e.g. energy, basic resources) may enhance overall returns.
Whichever way one chooses, the message is clear; do not assume that a plain eurozone inflation-linked government bond ETF is all you need to protect your portfolio from depreciation caused by inflationary pressures.
