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Last year, many mutual fund companies introduced active "Real Return" funds, which seek to outperform the CPI-U by allocating to inflation sensitive asset classes. However, the expense ratio for most such funds is well over 1% and their portfolios do not serve the exact needs of every individual or institutional investor.

Fortunately, there are low cost ETFs in most real return asset categories and moreover, these funds allow an investor to tailor the Real Return portfolio according to their income needs, risk tolerance and economic forecast.

Some ETF options within the four major real return asset categories are listed below:

Commodities

iShares: S&P GSCI Commodities Index

UBS E-Tracs DJ-UBS Commodity Index

Ticker

GSG

DJCI

Type

ETF

ETN

Net Expense Ratio

0.75%

0.5%

Assets

$2 Billion

$27 Million

Benchmark

S&P GSCI commodity Index

Dow Jones UBS Commodity Index

Allocation to Energy sector

69%

34%

BENCHMARK RETURN STATISTICS (1)

Annualized Return (10-yr)

4%

4.87%

Standard Deviation (10-yr)

28%

20%

Correlation to MSCI World (10-yr)

0.38

0.48

Correlation to CPI-U (10-yr)

0.69

0.56

On the basis of five year returns, the GSG might seem like a clear choice over the DJCI but the main driver for the fund's performance during this period was its higher allocation to energy. On the contrary, the DJCI invests about 33% in agricultural commodities and is likely to be more resilient during market crisis.

Natural Resources Equities

iShares S&P North American Natural Resources Index

SPDRS S&P Global Natural Resources Index

Ticker

IGE

GNR

Type

ETF

ETF

Net Expense Ratio

0.48%

0.4%

Assets

$2.5 Billion

$174 MM

Benchmark

S&P North American NR Index

S&P Global NR Index

Allocation to Energy sector

90%

33%

Allocation ex-North America

0%

58%

Allocation to Emerging Markets

0%

14%

BENCHMARK RETURN STATISTICS (1)

Annualized Return (10-yr)

12%

--

Standard Deviation (10-yr)

24.6%

--

Correlation to MSCI World (10-yr)

0.82

--

Correlation to CPI-U (10-yr)

0.42

--

The IGE holds about 145 companies and allocates approximately 90% of its portfolio to energy related firms. Contrarily, the SPDRS S&P Global Natural Resources ETF invests evenly in the agribusiness, energy and materials sectors and is geographically more diversified relative to the IGE.

TIPS

iShares Barclays TIPS bond fund

PIMCO 1-5 Year US TIPS ETF

Ticker

TIP

STPZ

Type

ETF

ETF

Net Expense Ratio

0.2%

0.2%

Assets

$20.4 Billion

$1.1 Billion

Benchmark

Barclays Capital US TIPS index

BofA ML 1-5 yr TIPS Index

Average Effective Duration

5.2 yrs

1.46 yrs

Yield

2.68%

1.38%

BENCHMARK RETURN STATISTICS (1)

Annualized Return (10-yr)

6.74%

--

Standard Deviation (10-yr)

5.34%

--

Correlation to MSCI World (10-yr)

0.20

--

Correlation to CPI-U (10-yr)

0.37

--

This asset class is inundated with very similar options and in addition to broad-based TIPS ETFs, there are vehicles which provide focused exposure to short or long maturity bonds within the TIPS universe. For example, the PIMCO 1-5 Year U.S. TIPS ETF only holds TIPS that have maturities below five years and hence, likely to be more responsive to inflation over the short to intermediate term. However, the fund has a lower real yield and is suitable only for investors who are concerned about inflation risk over the next 1-3 years. Therefore, investors with a longer time horizon would be better served by diversified broad-based TIPS ETFs like TIP and IPE.

REITS

Vanguard REIT ETF

SPDR Dow Jones REIT ETF

Ticker

VNQ

RWR

Type

ETF

ETF

Net Expense Ratio

0.13%

0.25%

Assets

$9.3 Billion

$1.6 Billion

Benchmark

MSCI US REIT Index

DJ US REIT Index

Number of stocks

104

82

Weighted Average Market Cap

5.60 Billion

$6.93 Billion

Dividend Yield

3.1%

3.1%

BENCHMARK RETURN STATISTICS (1)

Annualized Return (10-yr)

11.33%

--

Standard Deviation (10-yr)

26.5%

--

Correlation to MSCI World (10-yr)

0.71

--

Correlation to CPI-U (10-yr)

0.21

--

There are many diversified as well as specialized REIT ETFs available to investors. For example, the Vanguard REIT ETF, VNQ, has very low expenses and is ideal for long term investors. However, REITs have a much higher correlation with equities and hence, most diversified REIT ETFs are likely to struggle during difficult market environments.

Asset Class Characteristics

Category

Correlation to inflation

Diversification

Expected Returns

Expected Volatility

Commodities

Medium-High

Medium-high

Medium-high

High

Natural Resources

Medium

Low

High

High

TIPS

Medium

High

Low

Low

REITS

Medium

Low-Medium

High

High

Sample portfolios:

Category

Fund

Sample portfolio 1

Sample portfolio 2

Commodities

UBS ETracs DJ Commodities Index

25%

25%

Natural Resources

iShares S&P NA Natural Resources Index

25%

15%

TIPS

iShares Barclays TIPS bond

25%

45%

REITS

Vanguard REIT ETF

25%

15%

PORTFOLIO STATISTICS(1)(2)

Approximate Expense ratio

0.34%

0.31%

Annualized Returns (10-yr)

9.6%

7.8%

Standard Deviation (10-yr)

14.8%

10.4%

Sharpe Ratio (10-yr)

0.50

0.53

Correlation to MSCI World Index (10-yr)

0.80

0.56

Correlation to CPI-U (10-yr)

0.47

0.53

Both sample portfolios have comparable 10-yr Sharpe ratios and similar correlation with inflation but significantly different expected returns and risk characteristics. Due to this, each sample portfolio would appeal to a separate set of investors.

Sample portfolio 1 is equal weighted in the four asset categories and would appeal mostly to average long-term investors. Investors should also be aware that although sample portfolio 1 is likely to outperform sample portfolio 2 over the long term, the portfolio would mostly lag during difficult market environments due to it's higher allocation to REITS and natural resources equities.

On the other hand, since sample portfolio 2 has an overweight to TIPS and commodities, it is more suitable for investors with shorter time horizons and higher income needs. Moreover, sample portfolio 2 has higher correlation to inflation over the short to intermediate term and would most likely perform well in a scenario where headline inflation accelerates inspite of low economic growth.

We have outlined a very basic example of how portfolios consisting of these ETFs can be structured to adapt to an investor's needs. s specific circumstances and economic outlook. Investors can potentially enhance their portfolios' income and diversification characteristics by including MLP ETFS such as the Alerian MLP ETF (NYSEARCA:AMLP) and Credit Suisse Cushing 30 ETF (NYSEARCA:MLPN).

It remains to be seen if actively managed Real Return mutual funds such as HRLAX and PRDAX garner noteworthy interest from investors, but they have been well received so far. Although we think that these new Real Return products have some merit, our analysis suggests that a low cost approach using passive ETFs is certainly worth a consideration.

  1. All risk and return characteristics were calculated using the underlying benchmarks for the ETFs and are as of 03/31/2011
  2. Risk and return characteristics for the sample portfolios were calculated using the underlying benchmarks and the portfolios were assumed to be rebalanced annually.
Source: Using ETFs in Lieu of Mutual Funds for Real Return Portfolios