Taking a swipe at the scourge of inflation

After several years of low inflation and low interest rates, developed economies such as Europe, the UK and the US are now facing the return of higher rates of inflation. For investors, this means that the future purchasing power of their wealth is decreasing at a higher speed and their portfolios should be reviewed to ensure that adequate measures have been taken to protect against the scourge of inflation.

The Bank of England recently declared that inflation, - as measured by the consumer price index - has breached 4.4 per cent and is not expected to drop below the government’s official 2 per cent target until 2011. The retail price index, arguably a more accurate barometer for inflationary pressures for the UK economy, is already at 5 per cent and it is the index widely used for setting benefits, pensions and the return on index-linked gilts.

Inflation is particularly damaging to cash and fixed income investments, as it reduces the spending power of cash and the value of future cashflows. For many private investors, cash holdings are high, the result of relatively attractive interest rates on cash accounts and investor’s uncertainty over the direction of stock markets. Certainly, providers of high-end pensions, such as self-invested personal pensions, have reported high allocations to cash as well. What can investors do, therefore, to protect themselves from the corrosive effect of inflation?

An easy and efficient way to get exposure to inflation-linked bonds and thus get inflation protection is to use flexible and low cost exchange-traded funds. ETFs are tax-efficient and can be used in a Sipp or an Isa. They also combine the advantages of both index funds and stocks.

They are liquid, easy to use and can be traded in any quantity just like stocks. At the same time, an ETF provides the diversification, market coverage and low expenses of an index fund. These characteristics combine to create an investment tool that provides investors with the broad exposure they require, at the level they want, at the moment they need it. As such, they are fast gaining a reputation as an innovative investment solution – a claim greatly supported by the accelerated growth in ETFs. There are now more than 1300 ETFs with 2,207 listings, assets of $805.2bn (£409bn), managed by 79 managers on 42 exchanges.

Indeed, inflation-linked bonds are the only generic asset class that offers investors a direct hedge against inflation. The global inflation-linked asset class has rapidly increased over the past 25 years from virtually zero to around $1.5trn in insurance today.

Inflation-linked bond ETFs can be used for both strategic and tactical purposes in an investment portfolio. At a strategic level, they protect investors from both domestic and global inflation. “Home inflation protection” can be implemented with inflation-linked ETFs as each of them is linked to specific market inflation. The UK inflation-linked bond is linked to the RPI, while the US inflation-linked bond is linked to the US CPI index and the European index is based on the European HICP ex-tobacco indicator.