By Gordon Pape, Editor and Publisher
A year ago, no one was worried about inflation. Now everyone is, whether you’re a central banker or a supermarket shopper.
Monetary policy, which for the past two years has focused on supporting a pandemic-ravaged economy, is about to dramatically change direction. The Bank of England has already started to tighten, raising its key rate a quarter point in mid-December. The US Federal Reserve Board is expected to raise its rate four times this year, while ending its Quantitative Easing program. The Bank of Canada could raise its overnight rate as early as this week.
In short, we’re going into a full-scale war against inflation, even while the world still tries to recover from the economic impact of COVID.
What’s an investor to do in these circumstances?
One reader asked whether an ETF he’d discovered would be appropriate. It’s the VanEck Inflation Allocation ETF (NYSE: RAAX). The reader was impressed by its recent performance record and a distribution yield over 8%. He asked me to comment.
The VanEck funds are not well known in Canada, but the company is a prominent US money manager. It was founded in 1955 by the van Eck family and is still run by them. The firm has about $78 billion (all figures in US dollars) in assets under management.
This goal of this specific fund is to maximize real returns while seeking to reduce downside risk during sustained market declines. It’s a fund of funds that provides exposure to 22 other ETFs that invest in assets that should appreciate in inflationary times. These include commodities, real estate, infrastructure, energy, gold, and bitcoin, among others.
This is an expensive ETF, with a net expense ratio of 0.78%, which may be one reason why it hasn’t attracted much investor interest. Total assets under management are $34.6 million.
The fund posted a gain of 28.9% in 2021. But the three-year average annual return was much less impressive, at 5.7%. The fund was launched in 2018 and lost money both in that year and 2020. That wasn’t a surprise, since the ETF is structured to profit from inflation, which was not a significant issue until the latter part of 2021.
Distributions are paid annually, in December, and can vary significantly. The 2021 payout was $2.163 per unit, which would translate into a yield of 8.6% at the current price. But in 2020, the distribution was much less, at $1.392, and in 2019 it was only $0.609. With that record, yield shouldn’t be a determining factor in an investment decision.
Instead, the focus should be on the risk/reward potential. To assess that, let’s look under the hood of this fund.
The fund’s largest position is in the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (NDQ: PBDC), which accounts for 20% of the VanEck portfolio. The Invesco fund invests in commodity-linked futures and similar securities and is coming off a very strong year, with a gain of almost 42%. But its longer-term results are much less impressive, with a five-year average annual return of 5.9%.
Other large positions in the VanEck fund include the Vanguard Real Estate ETF (14.5% of the total) and the VanEck Merk Gold Shares (9.2%). There is one Canadian ETF in the mix: the Purpose Bitcoin ETF (1.9%).
I see RAAX as being suitable only for very aggressive investors. Yes, the portfolio is designed to combat the effects of inflation, but it is also risky by nature. Commodity futures, junior gold mines, oil and gas exploration and production companies, bitcoin, and other volatile holdings suggest a fund that is likely to be subject to significant swings in value. It’s also interesting to note that the fund has been in a downtrend after peaking in early November, despite the fact inflation has been escalating.
In short, it’s not a fund I would recommend. Anyone who does decide to buy should be prepared to dump the units if inflation starts to decline. You would not want to be holding them in a disinflationary environment.
I searched for other equity-based funds with a similar mandate and came up empty. There are several fixed-income ETFs and mutual funds that focus on inflation-protected government bonds, but nothing that directly competes with RAAX.
There are some elements in the RAAX portfolio that could be used to combat the effects of inflation with less risk. They include:
- Real estate. REITs are a good choice in an inflationary period because property prices will tend to rise, often at a faster rate than the CPI. The downside is that REITs are heavily leveraged so higher interest rates will hurt the bottom line.
- Infrastructure. The same considerations apply here. The asset values of railroads, toll roads, cellular networks, ports, etc. should increase. The carrying costs of financing will somewhat offset this.
- Materials. Commodity prices tend to rise during inflationary times and the shares of companies that produce them should follow. For example, a year ago Teck Resources was trading around $20. It closed Friday at $40.97.
- Energy. Oil prices have strengthened in the past year and the S&P/TSX Capped Energy Index was up almost 94% in the 12 months to Jan. 19.
- Banks. Rising interest rates tend to be good for bank profits. The S&P/TSX Capped Financials Index is ahead about one-third in the past year.
- Gold. We haven’t seen much evidence of this yet, but gold is traditionally a safe haven in inflationary periods. See Gavin Graham’s column elsewhere in this issue for more on this.
A fund that combined these asset classes would be very timely right now, offering inflation protection with less risk than RAAX. We’ll see if one emerges before this inflationary wave reaches its crest.
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