Inflation causing price rising up, overvalued stock or funds, consumer purchasing power reducing concept, air balloon tied with product price tag flying high rising up in the sky.
Nuthawut Somsuk

Preserving buying power is a perennial challenge for investment strategists. Especially during times like now: while fixed income yields remain low, inflation was recently running at nearly 5% in Canada, and even higher in the U.S.

To help sort through various inflation-resistant choices, TD Securities Inc.’s ETF research team released a strategy paper, Protecting Portfolios Against Inflation, in November.

“With rates being so low and inflation now on the upswing, it definitely impacts one’s portfolio,” said Andres Rincon, TD’s head of ETF sales and strategy. “So if you have an objective of a certain yield, or you have a low risk tolerance, then life in the investing world just got much tougher for you.”

The report identifies various sector- and factor-based equity strategies, two types of fixed-income ETFs, and two among the many alternative investments available through Canada-listed ETFs. It also suggests specific ETFs from various providers.

Under current market conditions, Rincon said, portfolios might need to be positioned a little more aggressively and tactically to protect buying power.

Doing so might entail investing in asset classes or sectors that investors wouldn’t necessarily want to always be fully exposed to or be overweight. “This is where tactical allocation is very important,” Rincon said. “And ETFs are a fairly liquid vehicle to do that.”

One tactical approach is to overweight equities sectors that can pass price increases to their consumers while managing expenses. These include energy and mining companies, as well as the real estate and consumer staples sectors.

Sector ETFs cited in the report include the iShares S&P/TSX Capped Energy Index ETF, iShares S&P/TSX Capped Materials Index ETF, TD Active Global Real Estate Equity ETF and BMO Global Consumer Staples Hedged to CAD Index ETF.

While REITs can provide inflation protection as rents and property prices go up, TD Securities sounded a note of caution. “Recent developments in faster rate hikes in Canada could impede some of that protection, as REITs are sensitive to rising rates.”

Among factor-based strategies, value-style ETFs tend to weather inflationary pressures better than those that hold growth stocks, according to TD Securities. As examples, the report cites Canadian, U.S. and international value index ETFs from Fidelity Investments Canada ULC.

Value stocks tend to be those of mature businesses with less need to take on debt than growth companies, Rincon said. He added that rising inflation — and higher borrowing costs — will have a more adverse impact on growth stocks than value stocks.

In the popular Canadian dividend category, TD Securities favours ETFs that screen stocks for dividend growth, not just above-average yields. Examples include the BMO International Dividend ETF, Invesco Canadian Dividend Index ETF and Vanguard U.S. Dividend Appreciation Index ETF.

These ETFs “build screens on companies that have a track record of paying a dividend but also are likely to continue to grow their dividends over time,” Rincon said. “This we find is the best way to combat rising inflation with your dividend-paying portfolio.”

The fixed-income inflation fighters identified by TD Securities fall into two main groups: ETFs that hold inflation-adjusted securities, and those with floating-rate holdings.

Among Canadian bonds, the BMO Real Return Bond Index ETF and the iShares Canadian Real Return Bond Index ETF track similar though not identical indexes, and hold top-quality Government of Canada credits.

Though their payouts are inflation-adjusted, these ETFs expose investors to high duration risk because they hold mostly long-term issues. Their average duration — or sensitivity to interest rate hikes — is about 16 years, roughly twice that of the whole Canadian investment-grade bond universe.

Increasing the duration of an investor’s portfolio by adding real-return bonds may not be a good idea because rising interest rates could depress the prices of long-term bonds.

For investors who already hold long-dated bond products, however, switching to a real-return bond ETF would provide inflation protection without increasing duration risk, Rincon said. “But if you don’t have any long-duration product, it would probably not be a good switch.”

ETFs that hold U.S. Treasury Inflation-Protected Securities (TIPS) have less duration risk. Though TIPS pay a fixed coupon rate, the principal amounts on which the coupons are based are adjusted for inflation.

TD Securities favours the two TIPS ETFs with shorter durations, namely the BMO Short-Term US TIPS Index ETF and the iShares 0-5 Year TIPS Bond Index ETF. Each has an average duration of about 2.5 years. While lower-yielding, these two ETFs are less vulnerable to rising interest rates while still providing protection against rising inflation, Rincon said.

Elsewhere in fixed income, floating-rate ETFs indirectly provide inflation protection by holding securities with payouts linked to changes in interest rates.

Providing passive investment-grade exposure is the iShares Floating Rate Index ETF. For active management, TD Securities favours the Dynamic Active Investment Grade Floating Rate ETF, which “has strong recent performance relative to its peers.” Higher yields, but with higher credit risk, can be had with ETFs that hold non-investment-grade floating-rate bonds and bank loans.

In non-core asset categories, TD Securities highlighted two alternatives. One is gold, which has been viewed as an inflation hedge for centuries. The other is cryptocurrency, the flashy newcomer.

Though volatile, and with weak recent performance in 2021, gold has been shown to hold its value in real terms historically, TD Securities said. “Growing risk of stagflation trends (rising inflation combined with stagnant growth) could increase demand for the yellow metal, which makes this asset class very compelling to own on a tactical basis.” The report favours the CI Gold Bullion Fund because of its low management fee of 0.155%.

As for cryptocurrencies, TD Securities said that while historical data is limited, cryptocurrencies have had relatively low correlations with traditional asset classes. For that reason, cryptocurrency ETFs “can be a way to diversify portfolios during a period of inflation.” The low-cost funds identified in the report are the CI Galaxy Bitcoin ETF and the CI Galaxy Ethereum ETF, each charging a management fee of 0.40%.