The Best ETFs To Own When Inflation Is High

Tom Madell profile picture
Tom Madell
1.53K Followers

Summary

  • Inflation is now well over the Fed's preferred level of 2% and promises to remain overheated during the remainder of 2022.
  • So the question becomes what categories of ETFs (or even mutual funds) an investor should consider owning in order to avoid the generally poor returns that inflation may bring.
  • I show which of a handful of Vanguard ETFs investors should include in their portfolios in order to maximize returns.

Dollar currency growth concept with upward arrows on charts and coins background

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One thing that everyone is certain about: Since the beginning of 2021, inflation has risen to heights not seen for many decades. So, an obvious question for investors seeking to do as well as they can under the circumstances is which types of funds will most likely lead to the best gains, even if those gains may be somewhat miniscule or even negative as compared to returns over most of the last 10 years prior to 2021 when inflation was mainly quite tame.

While inflation above the 2% level doesn't always hurt all stock and bond fund returns, as a general rule, inflation above this level can have a deleterious effect on many asset classes. But are there some categories of funds that have typically performed quite well in spite of inflation when going back a number of years? And which are the classes of ETFs (and similarly, mutual funds) that seem to have a track record of doing at least somewhat better than most other classes?

In a Dec. 2021 article entitled VTI ETF Investors: Even Moderate Inflation Can Be Damaging on Seeking Alpha, I reported on the relationship between one-year returns for the Vanguard Total Stock Market ETF (VTI) and year-end inflation figures as indicated by Consumer Price Index (CPI) readings over a 16-year period, excluding 2021 inflation full year figures which were not yet available.

I expected that during full years of relatively high inflation, the yearly return of stock ETF prices would be lower than in years of relatively low inflation. I showed that past performance data confirmed this expectation: When full year, year-over-year inflation was below the Fed's preferred 2% level, the average yearly return for VTI was 19.65%; when inflation was above 2%, the average yearly return was only 2.98%. However, we now know that inflation for 2021 was 4.7%, raising the comparatively high average inflation years for VTI returns to 5.50%.

In either case, this served as a strong suggestion that overall stock prices and many funds may be headed for a below par year in 2022. Of course, since VTI tracks the total US stock market, it is reasonable to assume that many subgroups of US stocks may also do poorly this year if inflation continues at an above 2% rate. And this is exactly what has been happening for the first three-plus months of 2022, with only a minority of funds in positive territory through April 8.

While inflation figures are only available through Feb. 2022, a new monthly report for March will be issued on April 12th. But we can at least get an estimate of what the entire year's inflation figure might be by looking at the Fed's own current estimate of what it might be. (Note that the Fed's March 16th estimate is considered by many, including me, to be too optimistic regarding their consensus judgment as to the improving effects of their planned interest rate increases this year.) That projection now stands at 4.3%. So, the way things now stand, 2022 seems highly likely to be a year of high inflation, quite likely negatively impacting overall stock prices.

But what about returns for other ETFs? Would years of high inflation be equally damaging to all categories of stock ETFs, and to bond ETFs as well? And would there be any Vanguard ETFs, one of the largest providers of ETFs, that would do better than most in years that inflation is relatively high as opposed to when inflation was relatively low?

The following list shows how CPI inflation has fared between 2021 and 2005 according to Federal Reserve data.

2021 4.7

2020 1.2

2019 1.8

2018 2.4

2017 2.1

2016 1.3

2015 0.1

2014 1.6

2013 1.5

2012 2.1

2011 3.2

2010 1.6

2009 -0.4

2008 3.8

2007 2.9

2006 3.2

2005 3.4

How to Measure the Effect of Inflation on ETF Performance

In order to judge the effect of this year-end inflation, we can examine how various Vanguard ETFs have done in each of these years.

By necessity, I selected only a small sample of Vanguard ETFs to include, some of which have typically been thought to do well or poorly in times of inflation. However, since Vanguard does not have an ETF for gold, widely thought to be a good hedge against inflation, I also included the SPDR® Gold Shares (GLD) ETF.

I next split the above list into two using 2% as the cut-off, showing years with the highest inflation at the top vs. those with the lowest at the bottom of each list. 2021 was the highest year for inflation, to no one's surprise, and 2009 the lowest, when inflation was actually negative.

High Inflation

2021 4.7

2008 3.8

2005 3.4

2006 3.2

2011 3.2

2007 2.9

2018 2.4

2012 2.1

2017 2.1

Low Inflation

2019 1.8

2014 1.6

2010 1.6

2013 1.5

2016 1.3

2020 1.2

2015 0.1

2009 -0.4

Now look at how each of my selected ETFs did in each of those years. Returns are as reported using the Backtest Portfolio Asset Allocation link on portfoliovisualizer.com

Vanguard Growth ETF (VUG)

High Inflation

Average one-year return: 6.59

Low Inflation

Average one-year return: 23.27

While there is a high degree of variability in the returns from year to year, it can be seen that an ETF consisting mainly of large cap growth stocks has done much better on average when inflation is relatively low. The difference should be regarded as too big to ignore.

Likewise, the identical procedure of separating one-year returns during the years of higher than Fed-preferred CPI to those realized during the lower inflation years was used to compute averages.

Vanguard Value ETF (VTV)

High Inflation

Average one-year return: 5.35

Low Inflation

Average one-year return: 15.59

Vanguard Interm-Term Bond ETF (BIV)

High Inflation

Average one-year return: 4.46

Low Inflation

Average one-year return: 5.09

Vanguard Short-Term Bond ETF (BSV)

High Inflation

Average one-year return: 3.04

Low Inflation

Average one-year return: 2.36

Vanguard Total Bond Market ETF (BND)

High Inflation

Average one-year return: 4.11

Low Inflation

Average one-year return: 4.15

Vanguard Energy ETF (VDE)

High Inflation

Average one-year return: 10.34

Low Inflation

Average one-year return: 5.58

Vanguard Financials ETF (VFH)

High Inflation

Average one-year return: 1.39

Low Inflation

Average one-year return: 16.24

Vanguard Materials ETF (VAW)

High Inflation

Average one-year return: 4.94

Low Inflation

Average one-year return: 20.12

Vanguard Real Estate ETF (VNQ)

High Inflation

Average one-year return: 6.60

Low Inflation

Average one-year return: 15.79

Vanguard Utilities ETF (VPU)

High Inflation

Average one-year return: 8.92

Low Inflation

Average one-year return: 12.14

SPDR® Gold Shares (GLD)

High Inflation

Average one-year return: 10.95

Low Inflation

Average one-year return: 7.85

Vanguard Total Stock Market ETF (VTI)

High Inflation

Average one-year return: 5.50

Low Inflation

Average one-year return: 19.65

Summary and Conclusions

While experts may disagree among each other, the above data shows the actual results that 12 ETFs have achieved over the past 17 years, some when inflation has been relatively high vs. when it has been relatively low.

These results support the notion that commodities such as energy and gold typically show good investment performance during periods of above Fed-preferred levels of inflation.

Somewhat surprisingly, a utilities ETF has also done well. Perhaps this is because investors may gravitate toward funds that pay relatively high dividends in times of when bonds should be avoided. Regarding this latter point, it can be seen that bond ETFs are among the worst performers when inflation has proven to be high, with an intermediate-term bond ETF doing better than the two other bond funds that invest in somewhat longer-term maturities.)

Funds that invest mainly within the value category as opposed to those investing mainly in growth may also turn out to be a somewhat better choice looking ahead. This is consistent with the findings presented by me here recently.

But the overall picture shows that aside from the top three performers mentioned above, most other ETFs averaged disappointing one-year returns during above average inflation. Therefore, it appears that for the most part, investors should not expect to see the kind of returns they saw when inflation remained low. The year-to-date returns for these latter funds further support this notion.

This article was written by

Tom Madell profile picture
1.53K Followers
Tom Madell, Ph.D., is the publisher of Mutual Fund/ETF Research Newsletter, a free newsletter which began publication in 1999 with thousands of readers. It has become one of the most popular mutual fund/ETF newsletters on the internet, as shown here. His site has been named as one of the "Top 12 Investment Newsletters Focusing on Mutual Funds" at mutualfunds.com , an important fund information provider, under "Fund Newsletter". Also, recently his Newsletter was recognized as one of 5 expert mutual fund resources worth following offering free, and, in its case, particularly "unbiased, useful, and original advice" at http://funds-newsletter.com/fundreference-art.htm .He is also a researcher/writer/investor whose articles have appeared on hundreds of websites, including the Wall Street Journal, USA Today, Morningstar and in the international media.His articles have been among the most popular among those posted on the Morningstar.com website by non-Morningstar employed contributors.His recommendations have an outstanding, long-standing record of success . His complete list of former articles can be accessed at http://funds-newsletter.com

Disclosure: I/we have a beneficial long position in the shares of VFH BND either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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