The Newest Way to Fight Inflation

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When a big stock market crash happens, it can wreak havoc on your financial security. But crashes don't happen very often, and they're typically followed by long bull periods during which you can make back much or all of what you've lost.

But there's an even bigger threat to the health of your personal finances, and it's a lot harder to fight -- especially right now. It acts so slowly that you often don't even notice it, but over time, it could put your financial health in jeopardy.

That threat is inflation, and even now, it's eating away at the purchasing power of your hard-earned assets. But recently, a new vehicle for fighting inflation became available. Is this new investment up to the task, or will you be better served sticking with old tried-and-true inflation-fighters? Let's take a look.

The new inflation ETFs
Last week, the ETF management company ProShares launched two new exchange-traded funds. The ETFs are designed to track what's known as the "break-even" rate between two types of Treasury bonds: traditional 30-year bonds and inflation-indexed Treasuries, also called TIPS.

The mechanics behind the index that the ETFs track gets complicated, but the idea is pretty simple. Regular Treasuries pay you a fixed interest rate, so you always know exactly how much income you're going to get when you invest in them. By contrast, TIPS have two components that make up their return: a fixed interest rate, plus an adjustment to account for changes in the Consumer Price Index. So while a regular $1,000 Treasury bond will always pay you back $1,000 when it matures, TIPS with a face value of $1,000 will pay you more or less than $1,000 depending on whether the CPI rises or falls between when the TIPS are issued and when they mature.

Because TIPS have that extra inflation component, the fixed rate they offer is usually less than the fixed rate on conventional Treasuries. That difference in the fixed rate represents what rate of inflation the market expects -- and if that rate actually occurs, then the total return on the two bonds will be exactly the same.

So should you buy the ETFs?
The first thing you need to understand is that the ProShares ETFs are tracking the expected rate of inflation, not the inflation that actually occurs. If you want to invest directly in TIPS that pay returns based on actual inflation, then the iShares Barclays TIPS Bond ETF (NYSE: TIP  ) is the biggest choice available to you.

With the ProShares ETFs, on the other hand, what will make you money is if those expectations for future inflation rise or fall. The two ETFs offer mirror-image exposure; one rises along with the break-even rate, while the other is tied to the inverse of the index, and therefore moves down if the break-even rate jumps.

Getting real protection
To me, the ProShares ETFs are too far removed from the actual effects of inflation. I'd rather invest in companies that will see their profits go up when price levels rise.

Lately, one obvious choice has been energy stocks. While natural gas prices have fallen through the floor, oil remains high, boosting Penn West Petroleum (NYSE: PWE  ) and SandRidge Energy (NYSE: SD  ) , both of which have largely shifted their focus away from natural gas and toward production of oil and other liquids.

Another idea is to invest in agricultural companies. Terra Nitrogen (NYSE: TNH  ) and CVR Partners (NYSE: UAN  ) have their fortunes tied largely to the price of food crops, as their fertilizers see increased demand when farmers can get higher prices for their harvests.

Why you need to fight inflation
These stocks aren't a perfect hedge against inflation, especially since prices rise at different rates in various industries. Energy and food costs won't get reflected in the prices you pay for health care, for instance -- you'd need exposure to health-care stocks to capture that phenomenon directly.

But the key is to understand that to fight against inflation, you need to go to the source. While the new ProShares ETFs serve a purpose by letting investors bet on the spreads between TIPS and regular Treasuries, you'd be better off looking elsewhere for true inflation protection.

Inflation is a constant battle, so don't let your cash lose its purchasing power. The Fool's latest special report can point the way to three stocks chosen to make long-term investors rich. It's free but only available for a limited time, so click here and read it today.

Fool contributor Dan Caplinger fights inflation every day. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy inflates like a balloon and is just as fun.

Read/Post Comments (2) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 19, 2012, at 1:13 PM, DJDynamicNC wrote:

    Good article, thanks for the heads up.

    Austintra6, please change your password, your account has been hacked by a spambot.

  • Report this Comment On January 19, 2012, at 1:14 PM, DJDynamicNC wrote:

    Oh wow, that was quick. :lol:

    Anyway, great to have this article here, I hadn't heard about the new ETFs but now I will be wary.

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