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12:00 14 Feb 2013 By Jose Garcia-Zarate

Inflation is one of the most pernicious forces faced by investors. Commonly described as a stealth tax; inflation chips away at investment returns. As such, one of the most basic rules of investment portfolio construction is that of making adequate provisions against it.

UK investors have been made particularly aware of such a need in the past few years as inflation has run well above the Bank of Englands (BoE) price stability target of 2.0%. Despite a gradual slide from the multi-decade highs of late 2011, UK inflation, as measured by the consumer price index (CPI), still remains above target. Moreover, the consensus expectation is for inflation to remain above target for a protracted period.

Although officially undeclared, since the start of the current crisis the BoE has actively pursued a weak sterling policy with the ultimate goal of rebalancing of the UKs economy towards export growth. While continuing to pay lip-service to inflation targeting, the fact is that inflation has become something of a secondary target for the purposes of UK monetary policy execution.

A few years into the experiment we are starting to realise that attempting to bring about long-lasting structural changes to a net-importing economy simply using foreign exchange differentials is perhaps too tall an order unless accompanied by deep supply-side reforms. Meanwhile, imported price pressures courtesy of a devalued pound have proved rather corrosive for savers and investors. The arrival of the new BoE Governor Mark Carney in the summer is highly unlikely to bring about a change of strategy. In fact, if anything, the risk is for the BoE to become even less preoccupied about inflation as a standalone economic variable in its quest to spur the elusive GDP growth. While a government overburdened with debt might see inflation as a welcome helping hand, the effect for savers and investors would not be positive. As a result, inflation protection for UK-centric portfolios may be the best move for many investors.

How To Protect Against Inflation?

Inflation protection should ideally be a multi-asset strategy, which involves mixing bonds, equities and commodities, and the portfolio should be carefully tailored to a set investment horizon. The inflation-fighting properties of some commodities have routinely been documented. Equities in particular those sectors bound to profit more from an expected rise in imported price pressures (e.g. energy) can also be part of the mix. However, for a sterling-based investor, the basic building block of an inflation-beating strategy is likely to come in the shape of UK inflation-linked government bonds.

Exchange-traded products (ETPs), which include exchange-traded funds (ETFs) and exchange-traded commodities (ETCs), allow investors to easily put together an inflation-shielding strategy within their portfolios. In most cases it will also be more cost-effective than using more traditional investment vehicles.

Regarding the specific case of UK inflation-linked government bonds, the ETF universe is still fairly small, with only three ETFs available as of this writing. There is the physically-replicated iShares BarCap GBP Index-Linked Gilts ETF (INXG), the swap-based db X-trackers iBoxx UK Gilt Inflation Linked ETF (XBUI) and the Lyxor iBoxx UK Gilt Inflation-Linked ETF (GILI). The annual management charge for the iShares ETF by far the most popular as measured in terms of assets under management is 0.25%. The Lyxor ETF charges 0.22% and the db X-trackers ETF charges 0.20%.

According to Morningstar data, these annual ETF charges compare very positively to those levied by similar actively managed and traditional index-tracking funds. Indeed, the average annual management fee for an active fund stands at 0.75%, with some going as high as 1.28%. Meanwhile the average management fee for a traditional index-tracker is 0.40%. If you think that cost is the single best predictor of future performance for any financial instrument and you should, as cost is the only ex-ante certainty when investing then the case for using ETFs for buy and hold purposes is pretty compelling.

RPI vs CPI

Gaining exposure to the UK inflation-linked government bond market via ETFs also automatically gives you extra-protection vis—vis the official measure of inflation (i.e. CPI), which further weakens the case of paying higher fees for the uncertain benefit of outperforming the underlying market. This is because UK government inflation-linked bonds are indexed to the retail price index (RPI) rather than CPI. RPI includes housing costs (such as mortgages) and it has proved to be a more volatile series than CPI. But crucially for investors, it has tended to overshoot CPI by a considerable measure; on average, its been 0.7% higher over the last decade. As such, UK government inflation-linked bonds would normally give you extra inflation protection from the get-go when measured against the BoEs CPI target. This will be duly reflected in the performance of the above ETF.

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The available ETFs cover the whole maturity spectrum of the UK government inflation-linked market. Investors should be aware that the bulk of UK government inflation-linked issuance is biased to long-dated maturities. As a result, the ETFs have high duration metrics. However, this would be the case for any other financial instrument providing exposure to this market. As I mentioned earlier, the ideal anti-inflation strategy is probably one made up of a mix of asset classes to account for different time horizons. But when it comes to cost, you will be hard-pressed to beat ETFs.

The original version of this article was published in Investment Week.

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