Inflation Can Quickly Erode Your Portfolio's Value: This Is the ETF Type I'm Counting On as a Hedge Against That Happening
Key Points
Treasury Inflation-Protected Securities are designed as a hedge against inflation.
TIPS, as they are known, offer interest payments that vary with inflation.
Inflation-proof investments help protect a well-rounded portfolio.
I'd love to be one of those cool, calm investors. But the truth is, I'm a natural worrywart. While I have no interest in putting the brakes on my overall portfolio, I look for ways to minimize risks. Lately, inflation has been heavy on my mind, which makes me particularly grateful for Treasury Inflation-Protected Securities (TIPS) -- specifically those included in a high-quality exchange-traded fund (ETF).
Looking for inflation protection? Look no further
Like other ETFs, TIPS ETFs are investment funds that pool your money with that of other investors to purchase a diversified portfolio of TIPS. These ETFs trade on major stock exchanges, allowing you to buy and sell shares just as you would with regular stocks.
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One advantage of TIPS ETFs is their ease of access and liquidity. Couple that with built-in inflation protection, and it's easy to see how TIPS ETFs fit neatly into the diversified portfolio of anyone who worries about inflation eating away at their investments.
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How TIPS work
While traditional bonds pay a fixed interest rate, TIPS' interest payments are directly linked to inflation. As inflation rises, the principal value increases, leading to higher interest payments. On the other hand, if deflation occurs, the TIPS' principal value can decrease. However, it's guaranteed to never fall below its original value at maturity.
In other words, TIPS won't allow your investment to be eroded by inflation.
What makes TIPS so attractive
To date, it's been tough for me to identify much about TIPS ETFs that would dissuade me from adding one to my portfolio. Here's a highlight of what makes them so attractive for investors who want a measure of security in trying times.
- Inflation hedging: If you're all about inflation-proof investments, you'll appreciate the way TIPS ETFs serve as a hedge against inflation. As grocery and gas prices rise due to inflation, so do the fund's interest payments and the value of the securities it holds.
- Diversification: TIPS ETFs provide instant diversification across a host of issuers and maturities. This diversification reduces the risk inherent in investing in individual securities.
- Liquidity: Unlike purchasing TIPS directly, TIPS ETFs can be traded throughout the day, providing greater ease of access when and if you need it.
- Low expense ratio: Most TIPS ETFs carry relatively low management fees, especially as compared to mutual funds.
Performance matters
A fund must be more than a hedge against inflation. As with everything portfolio-related, there must be potential for growth. One TIPS ETF that I'm currently eyeing is the iShares U.S. Treasury Bond ETF (NYSEMKT: GOVT). With a 30-day SEC yield of 4.37% and a 12-month trailing yield of 3.61% (as of July 7), the fund has provided a stable income stream. Add to that its 0.05% expense ratio, and it's a low-cost way to invest in U.S. Treasury securities.
Nothing is perfect, and TIPS ETFs are no exception
As much as I like TIPS ETFs, there are two critical issues to keep in mind.
- In a deflationary environment or during periods of low inflation, TIPS ETFs may underperform.
- The interest income from TIPS is subject to federal income tax, which can affect overall returns.
A TIPS ETF can't prevent inflation, but it can protect a portion of my money.
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