Profit From Higher Inflation With RINF

Summary

• Inflation remains excessively elevated.
• RINF is an effective inflation hedge ETF and could outperform if inflation remains elevated in the following months.
• An overview of the fund follows.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Ibrahim Akcengiz

The ProShares Inflation Expectations ETF (NYSEARCA:RINF) is an index ETF providing investors with a simple way to profit from increased long-term inflation and inflation expectations. It does so through a long position in long-term treasury inflation-protected securities, or TIPs, and a short position in long-term treasuries.

In my opinion, the fund is an appropriate choice for shorter-term traders wishing to speculate on higher inflation. On the other hand, the fund is an inappropriate long-term investment opportunity, as the fund's strategy is quite costly, and has low long-term expected and realized total returns.

RINF - Overview

RINF is an index ETF, providing investors with a simple way to profit from increased long-term inflation expectations. The fund's strategy is surprisingly simple, with only two positions: a long position in long-term TIPs, and a short position in long-term treasuries. Let's have a look at each of these positions, and how they interact.

Long TIPs

TIPs are securities issued by the U.S. Federal Government, with effectively no credit risk. TIPs pay little in interest, but are indexed to inflation, and so see higher returns when inflation increases. TIPs also see higher returns when inflation expectations increase, due to higher investor demand. RINF invests in long-term TIPs, which are very sensitive to interest rate movements. Expect significant losses if interest rates increase, as investor demand for low-yielding long-term debt tends to significantly decrease when rates rise.

In simple terms, returns are dependent on:

Returns TIPs = interest (low) + inflation (expectations and realized) + interest rate movements

RINF's TIPs position is very similar to a long position in the PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (LTPZ), a long-term TIPs index ETF.

Short Treasuries

Treasuries are securities issued by the U.S. Federal Government, with effectively no credit risk, same as TIPs. Treasuries pay moderate interest, higher than TIPs, but are not indexed to inflation. RINF focuses on long-term treasuries, which are very sensitive to interest rate movements, same as TIPs.

RINF is short long-term treasuries, so performance for this position is reversed. Instead of receiving moderate interest, the fund pays a moderate amount of interest. Instead of seeing significant losses if interest rates increase, the fund sees significant gains if interest rates increase.

In simple terms, returns are dependent on:

Returns short treasuries = - interest (moderate) - interest rate movements

RINF's treasury position is very similar to a short position in the iShares 20+ Year Treasury Bond ETF (TLT), a long-term treasury index ETF.

Long TIPs + Short Treasuries

RINF invests in long-term TIPs, and is short long-term treasuries. Returns for these positions are as follows.

Returns TIPs = interest (Low) + inflation (expectations and realized) + interest rate movements

Returns short treasuries = - interest (moderate) - interest rate movements

Combine the above, and we get the following:

Returns RINF = inflation (expectations and realized) - interest (LOW)

As can be seen above, RINF conserves the inflation exposure from long-term TIPs. Interest rate sensitivity is eliminated, as the long and short position cancel each other out. Interest rate payments are negative, from the short treasury position, but only slightly so, due to the positive interest rate payments received from TIPs.

RINF as a whole is very similar to being long LTPZ, and short TLT, as shown in the graph below (RINF in blue). RINF has slightly underperformed versus these two positions, due to costs, holdings drift, and small discrepancies in strategies and holdings.

Portfolio Visualizer

With the above in mind, let's have a look at the benefits of the fund.

RINF - Benefits

RINF provides investors with a simple way to profit from rising inflation, and has no interest rate exposures. This is a simple, yet potent, combination. Let's have a look at these two benefits.

Inflation Exposure

RINF's returns are strongly dependent on inflation, with higher inflation rates leading to strong, market-beating returns. As an example, the fund has posted returns of 13.2% YTD, a period of heightened inflation. RINF has significantly outperformed relative to most asset classes, including equities and bonds, and has moderately outperformed relative to most inflation hedge ETFs, including the Horizon Kinetics Inflation Beneficiaries ETF (INFL), and the Fidelity Stocks for Inflation ETF (FCPI).

RINF provides investors with a simple, strong way to profit from increasing inflation and inflation expectations, a benefit for the fund and its shareholders, and the fund's core investment thesis.

Interest Rate Sensitivity

Most funds focusing on TIPs are sensitive to interest rates, and see significant losses when interest rates rise. Interest rates tend to increase when inflation increases, which means most TIPs funds are only moderately effective as inflation hedges. In some cases, losses from higher interest rates can be higher than gains from higher inflation, as has been the case YTD for most TIPs funds.

Data by YCharts

Although there is nothing inherently wrong with interest rate exposure, my understanding is that most investors would strongly prefer TIP funds without said exposure. RINF delivers just that, as the fund's short treasury position effectively eliminates the fund's interest rate exposure. RINF, unlike most normal TIPs funds, has outperformed YTD, as it has not been affected by rising interest rates.

Data by YCharts

RINF is an effective inflation hedge, and does not suffer losses when interest rates increase. This is a simple, but strong, investment thesis, and makes the fund a solid investment opportunity for investors wishing to profit from increased inflation.

RINF - Drawbacks

RINF is a reasonably good trading opportunity, but it is not without risks and drawbacks. Two stand out: the fund's low long-term expected returns, and the fund's dependence on inflation expectations for its returns. Let's have a look at each of these two points.

Very Low Long-Term Expected Returns

RINF has very low long-term expected returns, as the expected returns from the fund's long TIPs position are low, and the expected returns from its short treasury position are negative. Due to this, and considering the costs associated with running these strategies, RINF's investors should expect long-term returns of 0% or lower, a significant negative. Positive long-term returns are possible, but unlikely.

RINF itself has posted returns of effectively zero since inception, very slightly outperforming relative to expectations. Gains are almost completely concentrated in the past twelve months, losses mostly occurred between 2013 and 2016.

Data by YCharts

In my opinion, the fund's performance since inception is consistent with very low, even negative, long-term expected returns. Returns only turn positive when inflation is elevated, which is always possible, but unlikely to persist for years on end. These issues are significant negatives for the fund and its shareholders, and make RINF an inappropriate long-term holding.

Dependence on Inflation Expectations

RINF's returns are dependent on realized and expected inflation. These two variables mostly move in tandem, but that is not always the case, as markets are not always perfectly rational, nor do investors have perfect foresight. RINF would not perform all that well if realized inflation increases, but expected inflation remain subdued.

This was somewhat the case during the second half of 2021, during which inflation increased from around 5.0% to around 7.0%, but inflation expectations remained mostly flat, in the 2.20% - 2.30% range.

Data by YCharts

RINF posted returns of around 5.0% in the time period above. These were reasonably good returns, but lower than those of long-term TIPs, or equities.

Data by YCharts

Returns would have been materially lower if inflation expectations had decreased instead of remaining flat. Realized inflation matters, especially in the long-term, but RINF is simply not going to perform all that well if investors expect inflation to decrease, and price TIPs accordingly.

In practice, markets are rarely significantly irrational, at least for long periods of time. In the example above, inflation expectations were flat, not down, in the face of rising inflation. Markets were overly optimistic about inflation, but not significantly so. Importantly, inflation expectations started to increase soon after, with RINF significantly outperforming YTD, as expected.

Data by YCharts

On a more negative note, RINF's returns have stagnated since June, for the same reasons as above: inflation expectations have decreased, even as inflation itself increases. In my opinion, and assuming inflation remains elevated, returns should pick up steam in the coming months, as was the case earlier in the year.

RINF's returns are partly dependent on markets acting rationally, which is not always the case. Still, markets are mostly rational, so this isn't a significant negative, but it is a negative nonetheless.

Conclusion

RINF provides investors with a simple way to profit from increased long-term inflation and inflation expectations. It is a fantastic trading opportunity for short-term traders and investors, but an inappropriate long-term holding.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.