There’s been more than a little bit of turbulence in the stock market in recent months as statistical evidence is now confirming what everyone has known for quite some time: inflation is on the rise. The Bureau of Labor Statistics has reported that the annual rate of inflation is now running at higher than 5%. That’s disturbing to the market because inflation had been hovering at a very tame 2% (or so) level for most of the past two or three decades.
Does rising inflation mean it’s time to head for the storm cellar with your investment portfolio?
Some might advise taking that direction. But the reality is that inflation ebbs and flows, and the current spike in the rate doesn’t necessarily mean a decade of double-digit inflation. That makes the most reasonable strategy to continue with your long-term investment plan, but to make a few modifications for inflation as an ongoing issue.
That doesn’t mean rearranging your portfolio by adding various types of exotic individual investments. Instead, you can invest in index funds that specialize in industry sectors likely to benefit from inflation.
That’s why we’re presenting our list of the seven best index funds for inflation in 2021.
Index funds provide the same advantages in dealing with inflation as they do during any other type of economic or financial environment. They give you an opportunity to invest in entire industry sectors, without the need to concern yourself with individual security selection or portfolio management.
Since index funds track an index that’s tied to a very specific industry sector or commodity, you’ll be able to get broad exposure to that asset class just by investing in a fund linked to it. The fact that you don’t need to choose which specific stocks or commodities to invest in reduces the likelihood of making a costly mistake. You can simply choose the fund that matches the sector you believe will perform well in an inflationary environment, then sit back and relax.
If you want to make your inflation index fund strategy completely passive, you can hold the funds in an account with M1 Finance. That’s a robo-advisor that allows you to choose the stocks and funds you hold in your portfolio, but then provides automated portfolio management, including periodic rebalancing. Best of all, your account can be managed free of charge and without commissions on the funds you purchase for your portfolio.
In choosing our list of the seven best index funds for inflation in 2021, we started by identifying the asset classes most likely to benefit from an inflationary environment. We then selected what we believe to be the single best index fund for each asset class.
Here is our list of the seven best index funds for inflation in 2021:
If past experience is any indication, energy is one of the best sectors to invest in during times of rising inflation. Energy is a base commodity that’s needed to power the entire economy. If inflation is affecting the general economy, it’s likely to be more concentrated in the energy sector.
One of the best fund plays on energy is the Invesco Dynamic Energy Exploration and Production ETF (PXE). Though it’s a small fund, its one-year performance of +80.67% has easily outdistanced the S&P Composite 1500 Oil and Gas Exploration and Production Index, which has returned just +62.42% over the past year. In addition, the fund is currently paying an annual dividend of nearly 2%.
The ETF concentrates allocations in small-cap value stocks (49%) and mid-cap value stocks (33%). The emphasis on value stocks may help to explain why it’s outperformed the related S&P index. Major holdings include ConocoPhillips, Occidental Petroleum, EOG Resources, Pioneer Natural Resources, and Hess Corp.
One of the very best overall strategies for dealing with inflation is to simply outgrow it. You can do that by investing in growth stocks. These are companies that have a track record of fast growth, prospects for still more growth, and a preference to invest profits back into the business rather than paying them out in dividends.
Perhaps the best single fund to invest in growth stocks is the Invesco QQQ ETF (QQQ). The fund tracks the NASDAQ-100 Index, which represents the 100 largest non-financial companies (based on market capitalization) traded on that exchange. The fund has had a 10-year average annual return of almost 23%, which has not only outdistanced inflation, but it’s also outperformed the S&P 500.
Even though the fund invests entirely in NASDAQ listed companies, they represent some of the biggest and most successful institutions of the world. Topping the list are Apple, Microsoft, Amazon, Tesla, Alphabet, Facebook, NVIDIA, PayPal and Adobe.
Though the fund has a low dividend yield (under 0.50%) and a relatively high average price-earnings ratio of 33, these are characteristics of growth stocks, and represent the kind of higher risk profile of companies that provide higher returns.
Though the healthcare sector isn’t considered to be a sector that performs well specifically during times of high inflation, the long-term returns make it a solid investment, even during times of rising prices. This has to do with the nature of healthcare itself. Since it’s essential to maintaining the health of the population, the sector is largely insulated from the damage inflation can cause with other industries.
An excellent play on healthcare is the Health Care Select Sector SPDR Fund (XLV). It’s the largest healthcare ETF, with nearly $33 billion in assets under management. This is an indication that investors are voting with their feet – or in this case, with their money – to invest in this fund.
It’s not hard to see why. Against an inflation rate above 5%, the fund has turned in a return of nearly 27% in the past year. And though the five-year is “only” a little over 15%, the 10-year average return is nearly 17%. This is largely because the fund includes some of the biggest and most successful companies in the healthcare field. Think Johnson & Johnson, UnitedHealth Group, Pfizer, Abbott Laboratories, AbbieVie, Merck and Eli Lilly.
It’s almost an article of faith that precious metals, and especially gold, are the best commodities to hold in an inflationary environment. But the performance of gold during 2021 is telling a different story. Gold has been dropping in price at the very time inflation has been accelerating.
The better play, at least up to this point, seems to be base metals. These are metals used in industry, and the combination of rising prices and spot shortages are causing these metals to become more valuable. Examples of base metals are aluminum, zinc and copper.
You can play base metals by investing in the Invesco DB Base Metals Fund (DBB). This fund attempts to match the performance of the DBIQ Optimum Yield Industrial Metals Index Excess Return, and the returns over the past year have been several times the rate of inflation.
DBB fund holds a fairly balanced mix of the three base metals, with allocations of 42.6% in aluminum, 39.13% in copper, and 30.51% in zinc. (The mix is subject to change, as market dynamics change.)
The fund does have a high expense ratio, at 0.84%. This is primarily due to the annual management fee of 0.75%. Investors should also be aware that the fund only occasionally makes distributions, the last one having occurred in December 2019. But if you believe base metals will be a good play against rising inflation, this fund deserves a place in your portfolio.
Real estate has a long history of strong performance during times of inflation. One of the classic ways to invest in real estate, short of buying individual properties directly, is through real estate investment trusts (REITs).
REITs are something like mutual funds that invest in commercial property. They can include apartment complexes, office buildings, warehouse space, retail centers, and other property types. REITs have the advantage of benefiting from income in two directions – distributions of net rental income, and capital gains upon disposition of properties within the portfolio.
But how do you know which REITs to invest in?
The JPMorgan BetaBuilders MSCI US REIT ETF (BBRE) can be the solution. It currently holds positions in 137 securities, including both REITs and small and mid-cap stocks engaged in the real estate industry. An investment in the fund will give you a diversified real estate portfolio that will take the guesswork out of deciding which specific slice of the industry is likely to benefit most.
With a one-year performance of better than 40%, including an annual dividend of more than 2.5%, BBRE is easily outperforming the current wave of inflation.
One of the most consistent investments in any type of economic environment – inflation, deflation, growth, or recession – is high dividend stocks. Not only do they pay high dividends consistently, but because they do, they tend to enjoy robust price appreciation over the long term. The combination of growth and income is tough to beat by any asset class. And over the long term, which is what really matters, they can also outperform inflation.
Probably the best index fund for high dividend stocks is the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). As the name implies, the fund tracks the S&P 500 Dividend Aristocrats Index (SPDAUDP). There are 65 companies included on the list, and they must meet certain qualifications to make the list.
Those qualifications include:
Given those requirements, it’s easy to see why this fund includes some of the biggest and best performing companies in the world. And because the index focuses on qualifications, companies included represent multiple industry sectors, including industrials, consumer staples, financials, healthcare, and consumer discretionary stocks.
The fund has an annual dividend yield of nearly 2% and has returned 31% over the past year. That covers the current annual inflation rate of about 5% several times over.
Despite rising inflation, it’s likely you’ll want to continue to hold a significant portion of your portfolio in bonds. But bonds typically have a negative reaction to inflation, due to their inverse relationship with interest rates. However, there is one bond category that’s designed specifically for inflation, and that’s Treasury Inflation Protected Securities, or TIPS.
Though they pay very low-interest rates, they provide a principal adjustment that’s tied to increases in the Consumer Price Index. That means the value of your TIPS will at least keep your principal value equal to inflation, while also providing a small interest rate return.
You can invest in TIPS through the Schwab US TIPS ETF (SCHP). It’s one of the most common TIPS ETFs used by robo-advisors, which means this is a fund you should consider for your own portfolio. It invests in the full maturity spectrum of the U.S. TIPS market and has one of the lowest expense ratios in the industry, at just 0.05%.
If you’re going to hold at least some of your portfolio in bonds, and you should, a big chunk of that should be held in TIPS. The SCHP is the perfect fund to do it with.
There’s no need to sell off all your current investment positions and then replace them with the funds listed above. Instead, you can invest a small amount of your portfolio in one or more of these funds. Additionally, you can direct fresh investment cash into the funds to avoid disturbing your current holdings.
There’s no way to know if the current spike in inflation is “transitory” (in Fed-speak), or if it could be a long-term trend. And even if it is, there’s no way to know if it will accelerate from where it is now, or simply tread water at or near the current level.
The most important strategy for dealing with inflation is to maintain growth in your portfolio. The funds listed above are likely to provide that growth, even if inflation doesn’t continue to be a problem, but especially if it does. A small corner of your portfolio, holding just two or three of these funds, could keep your portfolio well protected no matter what inflation does.