Ashish Arora submits:
Last year, many mutual fund companies introduced active "Real Return" funds, which seek to outperform the CPI-U by allocating to inflation sensitive asset classes. However, the expense ratio for most such funds is well over 1% and their portfolios do not serve the exact needs of every individual or institutional investor.
Fortunately, there are low cost ETFs in most real return asset categories and moreover, these funds allow an investor to tailor the Real Return portfolio according to their income needs, risk tolerance and economic forecast.
Some ETF options within the four major real return asset categories are listed below:
Commodities
| iShares: S&P GSCI Commodities Index | UBS E-Tracs DJ-UBS Commodity Index | |
|---|---|---|
| Ticker | [[GSG]] | [[DJCI]] |
| Type | ETF | ETN |
| Net Expense Ratio | 0.75% | 0.5% |
| Assets | $2 Billion | $27 Million |
| Benchmark | S&P GSCI commodity Index | Dow Jones UBS Commodity Index |
| Allocation to Energy sector | 69% | 34% |
| BENCHMARK RETURN STATISTICS (1) | ||
| Annualized Return (10-yr) | 4% | 4.87% |
| Standard Deviation (10-yr) | 28% | 20% |
| Correlation to MSCI World (10-yr) | 0.38 | 0.48 |
| Correlation to CPI-U (10-yr) | 0.69 | 0.56 |
On the basis of five year returns, the GSG might seem like a clear choice over the DJCI but the main driver for the fund's performance during this period was its higher allocation to energy. On the contrary, the DJCI invests about 33% in agricultural commodities and is likely to be more resilient during market crisis.
Natural Resources Equities
| iShares S&P North American Natural Resources Index | SPDRS S&P Global Natural Resources Index | |
|---|---|---|
| Ticker | [[IGE]] | [[GNR]] |
| Type | ETF | ETF |
| Net Expense Ratio | 0.48% | 0.4% |
| Assets | $2.5 Billion | $174 MM |
| Benchmark | S&P North American NR Index | S&P Global NR Index |
| Allocation to Energy sector | 90% | 33% |
| Allocation ex-North America | 0% | 58% |
| Allocation to Emerging Markets | 0% | 14% |
| BENCHMARK RETURN STATISTICS (1) | ||
| Annualized Return (10-yr) | 12% | -- |
| Standard Deviation (10-yr) | 24.6% | -- |
| Correlation to MSCI World (10-yr) | 0.82 | -- |
| Correlation to CPI-U (10-yr) | 0.42 | -- |
The IGE holds about 145 companies and allocates approximately 90% of its portfolio to energy related firms. Contrarily, the SPDRS S&P Global Natural Resources ETF invests evenly in the agribusiness, energy and materials sectors and is geographically more diversified relative to the IGE.
TIPS
| iShares Barclays TIPS bond fund | PIMCO 1-5 Year US TIPS ETF | |
|---|---|---|
| Ticker | [[TIP]] | [[STPZ]] |
| Type | ETF | ETF |
| Net Expense Ratio | 0.2% | 0.2% |
| Assets | $20.4 Billion | $1.1 Billion |
| Benchmark | Barclays Capital US TIPS index | BofA ML 1-5 yr TIPS Index |
| Average Effective Duration | 5.2 yrs | 1.46 yrs |
| Yield | 2.68% | 1.38% |
| BENCHMARK RETURN STATISTICS (1) | ||
| Annualized Return (10-yr) | 6.74% | -- |
| Standard Deviation (10-yr) | 5.34% | -- |
| Correlation to MSCI World (10-yr) | 0.20 | -- |
| Correlation to CPI-U (10-yr) | 0.37 | -- |
This asset class is inundated with very similar options and in addition to broad-based TIPS ETFs, there are vehicles which provide focused exposure to short or long maturity bonds within the TIPS universe. For example, the PIMCO 1-5 Year U.S. TIPS ETF only holds TIPS that have maturities below five years and hence, likely to be more responsive to inflation over the short to intermediate term. However, the fund has a lower real yield and is suitable only for investors who are concerned about inflation risk over the next 1-3 years. Therefore, investors with a longer time horizon would be better served by diversified broad-based TIPS ETFs like TIP and [[IPE]].
REITS
| Vanguard REIT ETF | SPDR Dow Jones REIT ETF | |
|---|---|---|
| Ticker | [[VNQ]] | [[RWR]] |
| Type | ETF | ETF |
| Net Expense Ratio | 0.13% | 0.25% |
| Assets | $9.3 Billion | $1.6 Billion |
| Benchmark | MSCI US REIT Index | DJ US REIT Index |
| Number of stocks | 104 | 82 |
| Weighted Average Market Cap | 5.60 Billion | $6.93 Billion |
| Dividend Yield | 3.1% | 3.1% |
| BENCHMARK RETURN STATISTICS (1) | ||
| Annualized Return (10-yr) | 11.33% | -- |
| Standard Deviation (10-yr) | 26.5% | -- |
| Correlation to MSCI World (10-yr) | 0.71 | -- |
| Correlation to CPI-U (10-yr) | 0.21 | -- |
There are many diversified as well as specialized REIT ETFs available to investors. For example, the Vanguard REIT ETF, VNQ, has very low expenses and is ideal for long term investors. However, REITs have a much higher correlation with equities and hence, most diversified REIT ETFs are likely to struggle during difficult market environments.
Asset Class Characteristics
| Category | Correlation to inflation | Diversification | Expected Returns | Expected Volatility |
|---|---|---|---|---|
| Commodities | Medium-High | Medium-high | Medium-high | High |
| Natural Resources | Medium | Low | High | High |
| TIPS | Medium | High | Low | Low |
| REITS | Medium | Low-Medium | High | High |
Sample portfolios:
| Category | Fund | Sample portfolio 1 | Sample portfolio 2 |
|---|---|---|---|
| Commodities | UBS ETracs DJ Commodities Index | 25% | 25% |
| Natural Resources | iShares S&P NA Natural Resources Index | 25% | 15% |
| TIPS | iShares Barclays TIPS bond | 25% | 45% |
| REITS | Vanguard REIT ETF | 25% | 15% |
| PORTFOLIO STATISTICS(1)(2) | |||
| Approximate Expense ratio | 0.34% | 0.31% | |
| Annualized Returns (10-yr) | 9.6% | 7.8% | |
| Standard Deviation (10-yr) | 14.8% | 10.4% | |
| Sharpe Ratio (10-yr) | 0.50 | 0.53 | |
| Correlation to MSCI World Index (10-yr) | 0.80 | 0.56 | |
| Correlation to CPI-U (10-yr) | 0.47 | 0.53 |
Both sample portfolios have comparable 10-yr Sharpe ratios and similar correlation with inflation but significantly different expected returns and risk characteristics. Due to this, each sample portfolio would appeal to a separate set of investors.
Sample portfolio 1 is equal weighted in the four asset categories and would appeal mostly to average long-term investors. Investors should also be aware that although sample portfolio 1 is likely to outperform sample portfolio 2 over the long term, the portfolio would mostly lag during difficult market environments due to it's higher allocation to REITS and natural resources equities.
On the other hand, since sample portfolio 2 has an overweight to TIPS and commodities, it is more suitable for investors with shorter time horizons and higher income needs. Moreover, sample portfolio 2 has higher correlation to inflation over the short to intermediate term and would most likely perform well in a scenario where headline inflation accelerates inspite of low economic growth.
We have outlined a very basic example of how portfolios consisting of these ETFs can be structured to adapt to an investor's needs. s specific circumstances and economic outlook. Investors can potentially enhance their portfolios' income and diversification characteristics by including MLP ETFS such as the Alerian MLP ETF ( AMLP ) and Credit Suisse Cushing 30 ETF (MLPN).
It remains to be seen if actively managed Real Return mutual funds such as HRLAX and PRDAX garner noteworthy interest from investors, but they have been well received so far. Although we think that these new Real Return products have some merit, our analysis suggests that a low cost approach using passive ETFs is certainly worth a consideration.
- All risk and return characteristics were calculated using the underlying benchmarks for the ETFs and are as of 03/31/2011
- Risk and return characteristics for the sample portfolios were calculated using the underlying benchmarks and the portfolios were assumed to be rebalanced annually.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
See also What Correlates With Bond Yields? on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
