How to Create Your Own Protection From Inflation

by: Bo Peng

As I have written recently, TIPS is a misnomer and offers only half inflation protection, which is not as bad as nominal treasuries, and half deflation protection, which is not as good as nominals. So how to protect yourself from inflation?

This is easy for professionals. They could do inflation swaps, or asset swaps (swapping nominals for TIPS of similar maturity), or any of a host of other derivatives. But most pros don't need to protect themselves from inflation - it's nice to make money from it, but their lives don't depend on it as is the case for many individual investors.

Individual investors could invest in whatever may take their fancy and hope for better-than-inflation nominal returns. But it would be nice to have something specifically designed for inflation protection. I'm quite surprised nobody has come out with an inflation ETF yet, which would be trivial to create and manage (if you do create one after reading this, a token share of the management fee would be nice ...). But until then, you could create your own inflation protection.

The idea is very simple: Nominals yield - TIPS yield = CPI expectation. Therefore you are long the TIP ETF and short IEI. As shown by the chart below, the blue line (value of the inflation protection porfolio) matches the orange line (5-Y CPI expectation) reasonably well.

Click to enlarge

Blue line is the value of inflation protection, based on long $10k of TIP and short $10k of IEI on 4/23/2007, when both became available. ETF prices based on adjusted price from Yahoo Finance. Orange line is 5-year CMT yield - 5-year TIPS yield.

A few notes:
1. IEI may be hard to short. And, depending on your broker, shorting involves margin requirements, which may be an indirect source of risk, and may carry extra charges.
2. Why use IEI over other treasury ETFs? Answer: maturity. The average duration for TIP ETF is around 5 years, and IEI is the closest I can find on the nominal side. If you pair TIP with, say, BIL (very short-term nominals), you'd be exposed to a few other factors.
3. Why use TIP instead of other TIPS ETFs? Answer: liquidity. This may not be a major concern since the underlying is Treasuries. You could do your own study using, say, IPE.
4. Why not long inverse ETFs/ETNs? Answer: inverse ETFs/ETNs are generally not a good idea for any time horizon beyond a few days, at least for hedging purposes. If you want to make a directional bet that you feel extra confident about, you might consider leveraged ETFs/ETNs, if you know what you're getting into.
5. As inherent to any inflation protection, when there's deflation or a major crisis, you'll lose money. But this is a low-cost, easy way to play inflation in about as pure form as it gets.
6. Does CPI expectation derived from Nominal-TIPS have anything to do with real inflation? Answer: this only deals with CPI and there's no direct and simple way to play against "real inflation," which of course depends on how you measure it.
7. The best way I know of to protect against "real inflation" is gold (GLD, PHYS, DGP), silver (SLV, PSLV) and commodities (DBA, DAG), at least until the Fed manages to restore its trust as the custodian of the world's reserve currency. But, since it's an indirect hedge, how to set the "hedge ratio" is a big question.
8. While I have 100% confidence that the Fed will be late in combating inflation (as confident as Bernanke is about controlling inflation), there are plenty of potential potholes and ditches along our joyous climb up the inflation hill.

Disclosure: I am long GLD, SLV, DBA.