David Stevenson: A hedge against inflation, and a play on energy

If, like me, you think that the future for adventurous investors is to give up on share tips and star fund
managers and concentrate on tracking asset classes, then I suggest taking a look at some of the new
US index funds.

Two in particular have caught my attention over the past few weeks: they offer a better way of
hedging against inflation, and a clever idea based around infrastructure.

Inflation is already making investors fret about the next few years. Fear of a return of inflation, or the emergence of the ungodly spectre of stagflation, is one of the main drivers of the gold price – which, in my view, is unsustainable and heading for bubble
status. Concerns over monetary fiat and a world of unsustainable foreign exchange rates is the other.

Personally, I think these fears are overdone in the short term, if only because of the huge excess capacity in the developed world economies.

But even I can’t ignore the growing perception of risk and how that’s driving prices. So, if I’m unconvinced that gold is a hedge against (fear of) inflation, what should I look at?

IndexIQ now offers an Inflation Hedge exchange-traded fund (ETF) – NYSE ticker symbol CPI (geddit?) – which aims to mimic the strategies deployed by hedge funds to protect against inflation.

In practical terms, that means it has large holdings in other ETFs such as the iShares Barclays Short Treasury Bond Fund and the Spider ETF Barclays Capital 1-3 Month T-Bill. Gold, commodities and forex holdings make up just under 9 per cent of the rest of the portfolio, giving the fund a total expense ratio of 0.65 per cent a year (including the cost of the underlying ETFs).

To me, this is a great way to buy cheap inflation protection if you deem it necessary – with the only obvious drawback being the currency risk of holding dollar-denominated assets.

Infrastructure interests me far more, however – and here the clever idea involves Master Limited Partnerships (MLPs).

Most UK investors won’t know about these US tax-efficient vehicles, but they should. MLPs develop and buy infrastructure assets, such as pipelines, and then sit back and collect the annual rental – subject to regulatory limits based on a return-on-equity formula.

Crucially, the MLPs must distribute 90 per cent of their profits as income payments, and most MLPs yield between 5 and 12 per cent a year, depending on their risk level (which in turn depends upon the age of the assets they hold – new-builds or projects under construction are the riskiest).

But don’t automatically assume that all these MLPs are a straight play on energy prices.

Much of the upside depends on the actual quantities shipped or on regulatory intervention – which can be immensely complicated and is
frequently the subject of much wrangling.

That complexity also adds risk, of course. Even if you analyse the return on equity and decide infrastructure is for you, how do you access the sector cost-effectively and in a diversified manner?

JP Morgan has the answer. It now offers an instrument called an exchange-traded note (ETN) that tracks an index of MLPs complied by a
company called Alerian.

This ETN is not cheap, with a total expense ratio of 0.85 per cent per year
– but it does track all the big MLP shares and is
currently paying out just over 6 per cent a year in income.

If you are interested in this idea, you absolutely need to do your research.

I can offer some help, here: if you email me at adventurous@ft.com, I
will send you some very detailed presentations
provided by the MLPs’ main trade body.

But on top of the asset class risk, you also need to understand the risk of investing via an ETN. This is a note backed by the bank (JP Morgan) and so it doesn’t actually comprise
a fund of the underlying securities in the index.
It is, in effect, an IOU.

Still, I think this could
be a great way of buying access to a well-regulated, relatively safe asset class with an emphasis on
providing an income and some upside potential via its stakes in the energy and transport sector.

Book offer: Indexing infrastructure

JP Morgan’s exchange- traded note tracks an index of infrastructure Master Limited Partnerships, but the easiest way to understand how these make their money is to read a blog by Bronte Capital, at http://brontecapital.blogspot.com/2009/12/when- regulators-cant-do-math-gas.html Given the need for energy infrastructure in the US, I think this is a compelling opportunity for investors looking for a better income stream than is available from UK-listed vehicles, such as 3i Infrastructure and HICL. But if an index-tracking approach to infrastructure seems confusing, help is at hand. My new book, The Financial Times Guide to ETFs and Index Funds, has just been published – and FT Money readers can buy it at a 35 per cent discount. Just visit www.pearson-books.com/etf

● A clarification: in my column on multi-ETF
portfolios last week, I got my acronyms mixed up when I was describing the newest entrant to this sector. The firm providing multi-ETF platforms to advisers is actually www.wkhfs.co.uk.

adventurous@ft.com