A New Approach to Inflation Defense: WisdomTree Launches Real Return ETF

Jul.14.11 | About: WisdomTree Global (RRF)

WisdomTree rolled out a new ETF designed to deliver a comprehensive approach to combating inflation, unveiling the Real Return Fund (NYSEARCA:RRF). The actively-managed ETF will take a unique approach to delivering total returns that outpace the rate of inflation, going beyond many of the more simplistic strategies that may have limited effectiveness when rising prices put a dent in portfolio values. The new RRF features a number of different components, each optimized to deliver a very unique risk/return profile to investors concerned about the potentially adverse impact of surging inflation.

Part I: TIPS (With a Global Feel)

From a high level, RRF will be split between inflation-protected bonds (about two-thirds of the portfolio) and commodities (one-third of the portfolio). The principal of inflation-protected bonds is generally linked to an official measure of inflation, meaning that as CPI (or some other indicator in the case of international securities) rises, the principal - and therefore coupons - of the bond also increase.

Unlike most ETFs in the Inflation Protected Bonds ETFdb Category, however, RRF won’t invest exclusively in U.S. TIPS. The bond portion of the portfolio is split between the U.S., developed markets and debt of emerging market issuers. Since inflation doesn’t always strike the indicators maintained by various countries evenly, that geographic diversification could be an important component of a well rounded inflation strategy. The current environment is a perfect example. Inflation in India and other emerging markets has accelerated dramatically, while the CPI reading in the U.S. and other developed markets remain relatively tame.

RRF will focus on bonds from issuers in major commodity-producing economies such as Australia, Brazil, Canada, Chile, Mexico and South Africa, but will also include debt from less commodity-intensive economies as well.

While inflation-protected bonds are one of the most widely-used safeguards against inflation, there are some limitations to this asset class in this role and ample evidence that an optimal inflation defense strategy must go beyond TIPS. Inflation-protected bonds are, after all, bonds, meaning that interest rate hikes can have an adverse impact on valuations. Since rates tend to rise when inflation kicks in, this relationship can potentially pose a problem to investors looking to protect against inflation.

Moreover, investors have flocked toward TIPS in recent years as anxiety over a surge in inflation has crept in. That trend has pushed down yields to near-zero levels. In fact, some TIPS have exhibited negative yields in recent months, meaning that the yield trade-off to achieve inflation protection can be significant. The inclusion of international debt, particularly inflation-linked bonds from emerging markets issuers, will generally result in a more substantial yield relative to strategies that focus exclusively on U.S. TIPS.

“Economies around the world are experiencing inflation at different speeds but U.S. investors should be aware that inflation around the globe can directly impact them,” said Bruce Lavine, WisdomTree president and COO. “We believe investing in U.S. TIPS alone is simply an incomplete inflation fighting strategy. We have designed the Global Real Return Fund as a diversified, multi-asset class approach to combating inflation.”

Part II: Commodities (Long, Short and Gold)

The other component to RRF is exposure to commodities, another asset class that has historically had appeal as a hedge against inflation. That link is equally straightforward. Because inflation results in higher prices for raw materials and natural resources, exposure to these assets can be desirable when prices begin to rise.

Again, the commodity exposure offered is a multi-pronged approach. A component of the commodity section of the portfolio will offer long exposure to a broad-based basket of natural resources through swaps and futures contracts. Another segment of the commodity exposure will utilize a long-short strategy guided by a rules-based approach that is generally similar to the methodology employed by the WisdomTree Managed Futures Strategy Fund (NYSEARCA:WDTI).

RRF will also maintain a position in gold, as this precious metal maintains some important benefits as part of an inflation protection strategy as well.

Inflation ETF Options

The objective of RRF is perhaps most comparable to a similarly-named product from IndexIQ. The IQ Real Return Fund (NYSEARCA:CPI) seeks to deliver a real rate of return above inflation, as measured by CPI. That ETF, which debuted in 2009, is structured as an ETF-of-ETFs that uses complementary holdings around a core position in short-term bonds in its attempt to beat inflation.

Disclosure: No positions at time of writing.

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