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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.

To protect against global inflation, a combination of sterling index-linked gilts, euro inflation-linked bond and dollar TIPS can be held, as three of these jointly cover 85 per cent of the world inflation market. This would also improve diversification, both within the overall portfolio and between mentioned above markets, where the correlation between respective inflation rates has historically been low.

At a tactical level, inflation-linked bond ETFs can be used to take positions on inflation expectations. For example, if an investor expects inflation to be higher than market expectation, they could go long on the inflation-linked bond ETF and underweight a matching conventional bond ETF.

Traditionally, equities have been regarded as an indirect hedge against inflation, as the equity risk premium should give an additional return over the risk-free rate, or the return on cash. However, inflation can be harmful to equities, as high inflation expectations make equity market participants more risk-averse in the asset allocation decision-making process. In addition, the mixed economic prospects may make investors wary of increasing their equity exposure at present.

Other indirect hedges against inflation include property, commodities and precious metals such as gold. These are classified as real assets, as opposed to financial assets, such as bonds, and historically they have been used as a bulwark against inflation. However, their value can be affected by supply and demand forces, giving large fluctuations in value.

Experts have been predicting that high crude oil prices, which have been at their historically highest level, would inevitably lead to higher inflation and this relationship is shown by the graph comparing US inflation rates and the oil prices.

However, even though oil is considered the biggest contributor to the world inflation, it is important to remember that the causes of inflation can vary for different countries and regions. So in Europe and the US, for instance, rising food and commodity prices are the key factors at the moment. In the UK, on the other hand, housing prices have been a significant driver of inflation.

Since the last bout of inflation in developed economies, the supply of index-linked bonds has increased from virtually zero in 1996 to around 12 per cent of the world government bond market now. In broad terms, inflation-linked bonds protect bond holders against the effects of inflation by increasing payments in line with inflation index.

Inflation has always been an important factor to consider, but now in an inflationary environment it is even more important for investors to take it into account. Investors should consider using inflation-linked bond ETFs as a new weapon in their armoury to combat inflation and to help mitigate the negative effects that both domestic and global inflation has on their wealth.

Alex Claringbull is senior fixed income portfolio manager at iShares