Inflation hedges attractive, but…

Ask financial advisers about their biggest concern over the next 12 to 18 months and most will talk about their fears of inflation.

And many of these advisers are turning to ETFs of commodities or Treasury inflation-protected securities to help them. The mammoth $62.2 billion SPDR Gold Trust Ticker:(GLD) was the most re-searched exchange-traded fund on Morningstar Inc.’s Advisor Workstation for the first half of this year. BlackRock Inc.’s $21.4 billion iShares Barclays TIPS Bond ETF Ticker:(TIP) came in second.

But commodities and TIPS ETFs come with their own set of problems, and there are many other ways to hedge against inflation using ETFs, experts said.

“People say they want inflation protection, but what they really want are things that go up,” said David Nadig, director of research at IndexUniverse.com.

Because ETFs enable advisers to target a specific asset class in a way mutual funds can’t, advisers should look broadly at what their options are, said Tim Strauss, an ETF analyst at Morningstar. “That means there are a lot of ETF strategies that an adviser can narrow in on that will help to hedge against inflation.”

ETFs also are good tools for hedging against inflation because they are low-cost, transparent and enable advisers to get in and out quickly without the same kinds of tax consequences that mutual funds impose, said Matthew Tucker, head of fixed-income strategy for iShares.

TIPS ETFs have been the most popular way advisers have used ETFs to hedge against inflation risk, attracting $1.48 billion in net flows for the first half of 2011, according to Morningstar.

“I think what is appealing about the iShares TIPS ETF is that it provides pure exposure to TIPS,” Mr. Tucker said. “The adviser gets real precision to really dial in on the exact asset allocation and client exposure they want.”

But TIPS ETFs are not a comprehensive safeguard against inflation, Mr. Nadig said. “When you are buying an inflation-protection security, you are getting that capital adjustment, but when you are buying a portfolio of TIPS toward a specific maturity, you are subjecting yourself to the vagaries of the market.”

PROS AND CONS OF COMMODITIES

Commodities ETFs, another popular tool among advisers to hedge against inflation, come with pros and cons, as well.

“If you think you are going to see higher food prices and higher oil prices, then you can hedge by buying commodity-specific ETFs,” said Tom Lydon, president of Global Trends Investments.

Two commodities ETFs that have done particularly well are the $3.1 billion PowerShares DB Agriculture ETF Ticker:(DBA) and Van Eck Global’s $5.2 billion Market Vectors Agribusiness ETF Ticker:(MOO).

Investing in commodities through ETFs is smart, experts said, particularly as the price of such commodities as food and oil can be affected by a number of factors, and investors want to be able to get in and out quickly.

“Corn is at an all-time high, not because of fears of inflation but because we had a crappy planting year,” Mr. Nadig said.

But advisers need to be aware that most commodities ETFs, except for those that invest in precious metals, don’t hold the physical commodities. Instead, they use futures contracts to provide exposure. This means that these portfolios are constantly buying and selling futures contracts to maintain the required exposure.

During a period in which commodities prices are rising, futures contracts — which oblige a buyer to purchase the commodities in the future — keep getting more expensive than the prevailing spot price.

This pricing condition is known as contango. (When futures prices are lower than the spot price, due to expectations of an economic slowdown or a glut of supply, for example, commodities are said to be trading in backwardation.)

For many commodities ETFs, such as United States Oil (USO), this can be particularly crushing because it is designed to roll into the next month’s futures contract, which keeps rising in price ahead of the spot price.

“A lot of first-generation commodities ETFs like USO have been remarkably poor long-term investments because of contango,” Mr. Nadig said. “You better be paying a lot of attention to the futures curve.”

Some advisers, such as Mr. Lydon, are turning to emerging-markets ETFs to help hedge against inflation. “One play for us [is] to have other countries that are also heavy commodities plays,” he said.

For example, Mr. Lydon likes the iShares MSCI Brazil Index ETF Ticker:(EWZ).

CURRENCY PLAYS

Investors worried about the decreasing value of the dollar might want to consider ETF strategies that will go up when the value of the U.S. dollar decreases, Mr. Nadig said.

For example, the PowerShares DB U.S. Dollar Index Bearish ETF Ticker:(UDN) bets against the dollar. Another option is to short PowerShares’ DB U.S. Dollar Index Bullish ETF Ticker:(UUP), Mr. Nadig said.

And ETF providers are launching more floating-rate ETFs to help investors hedge against rising interest rates.

So far this year, BlackRock, Van Eck Global and PowerShares have launched floating-rate ETFs, the first of their kind.

The PowerShares Senior Loan Portfolio Ticker:(BKLN) was one of the most successful ETF launches in the first half of this year, bringing in $182.15 million in net flows, according to IndexUniverse.

GOING SHORT

Advisers willing to take on extra risk also can use ETFs to short Treasuries, Mr. Strauss said. “There are ETFs now that have better structures for this than mutual funds,” he said.

The most popular of these ETFs is the $5.9 billion ProShares UltraShort 20+ Year Treasury Ticker:(TBT). But advisers who want to use this ETF need to pay attention, Mr. Strauss said. “This ETF resets its leverage daily, while most ETFs do monthly resets,” he said. “It’s good for day trading.”

Advisers who decide to try out some of the newer ETFs to hedge against inflation need to be cautious, Mr. Strauss said. “Some of these products are new and don’t have high trading volumes, or use limit orders,” he said. “You don’t want to get a bad price because of low liquidity.”

Related Topics: E*Trade Financial Corp., Inflation