After a strong recent jobs report and millions of administered vaccines, the economy finally appears to be zooming forward. But a revving economy also means rising inflation. The Federal Reserve Board members forecast a median inflation rate for personal consumption expenditures of 2.4% for 2021, twice the inflation experienced in 2020.
Often, when inflation becomes a concern, investors flock to commodities because the prices of these real-world goods usually rise with inflation. But commodities aren’t the only way to mitigate the erosion inflation can cause to long-term investments.
We spoke with Mark Carlson, senior investment strategist at FlexShares ETFs, about how investors can use natural resources as a hedge against inflation. Here are edited excerpts from the interview.
Why should investors consider investing in natural resources?
There are several reasons why natural resources investments make a compelling opportunity now and in the future.
First, it’s important to note the demand for natural resources is expected to increase due to growing populations and rising per capita income in global markets. Having exposure to natural resources provides an opportunity for investors to capitalize on rising natural resource input prices because of this demand.
Second, investing in natural resources can help individuals address key investment objectives such as inflation hedging, income generation, capital appreciation and portfolio diversification.
What is the advantage of using a natural resources exchange-traded fund as opposed to investing directly in a physical commodity?
Investing in a natural resources ETF is more practical than investing directly in a physical commodity. Outside of precious metals, it’s difficult to physically hold a natural resource. How does the average investor store 1 million cubic feet of natural gas? Further, while private ownership of energy reserves, timberland and mineral rights are available, they’re highly illiquid and often have limited groups of investors.
Another advantage to the ETF is its ability to transact, allowing daily liquidity to enter, exit and rebalance exposure. An ETF will typically have a much broader investor set and offer investors a transparent, economical and efficient means to constructing portfolio positions.
Most importantly, ETFs offer greater, broader exposure, giving investors potentially more upside and diversification. Funds like our FlexShares Morningstar Global Upstream Natural Resources Index ETF (ticker: GUNR) take a balanced approach to natural resource exposure. Through GUNR, investors gain exposure to key sectors within natural resources, including energy, metals, agriculture, timber and water resources.
How can investors hedge inflation with a natural resources ETF?
Companies within natural resources ETFs offer close to direct ownership of natural resources, which result in their revenues, earnings and cash flows being driven by the prices of natural resources. In turn, this provides a better correlation to inflation as those natural resource prices make their way through the economy in the form of housing, fuel, food and more.
Unique and diversified sector allocations also contribute to more stable long-term inflation hedging results. For example, GUNR’s water allocation has been a stabilized force within the investment returns of the fund, while providing inflationary hedging against more volatile sectors such as energy.
The fund’s allocation to timber also serves as a long-term inflation hedge. Research has shown that, out of all the major hard natural resource asset classes, timberland has some of the highest correlation to long-term inflation.
What are the advantages of water in a natural resources ETF?
Amid rising demand for water around the world due to urbanization and population growth, water companies stand to grow. But the world’s water systems face formidable threats, and the prospect of shortages in the years ahead could make water both a precious commodity and a valuable asset. Investors with exposure to water in their portfolio will be ahead of the game.
What benefits and risks should investors and advisors be aware of when considering a natural resources ETF?
Investors and advisors should be cautious of legacy natural resources investment strategies that are prone to overconcentration in industries like energy and metals, as it may potentially skew overall returns. Rather, investors should seek a strategy of balanced, strategic exposure to a broad, diversified array of natural resources equities ETFs.
Investors should also take into consideration their exposure to either the upstream or downstream portion of the supply chain. Upstream companies sit at the start of the supply chain and produce or extract resources that are then transported to processors. Ownership interests in upstream natural resources segments offer investors profitability benefits from natural resource price increases.
On the other hand, downstream companies process natural resources into consumer goods. Companies operating in these segments, after having paid for the resource, may face innumerable challenges in dealing with packaging, distribution, marketing, branding, changing consumer tastes and other factors that can impact their profitability and cash flows.
We advise investors use an investment strategy focused on companies involved in the upstream components of the natural resources supply chain that may capture the favorable growth and price impacts of rising demand.
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Q&A: Using a Natural Resources ETF to Combat Inflation originally appeared on usnews.com