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The Reflation Trade Portfolio

The Reflation Trade Portfolio

Written by Matthew Hougan
Thursday, 21 May 2009 13:11  |  Related ETFs: DBC / TBT / TIP / VAW / WIP

Earlier this morning, I was supposed to take part in a discussion on CNBC about how to use ETFs to build a "reflation portfolio."

We had technological difficulties in Maine, however, and couldn't get the satellite hookup going in time.

Even so, I thought it might be interesting to share the portfolio we were going to discuss. It brings up both an important as well as an interesting topic.

According to Wikipedia, "Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output."

Reflation is not necessarily good or bad, of course. The response from the Fed, the Treasury and Congress over the past few quarters probably saved us from a more crushing recession/potential depression.

But the challenging part comes next. Can the Federal Reserve and the Treasury drain money out of the system just right so that they don't: 1) stunt the recovery; and 2) create runaway inflation?

Color me skeptical. It seems like the "thread-the-needle" or "goldilocks" scenario is the least likely outcome. Far more likely is that political pressure (and natural optimism) will force the government to leave its foot on the pedal for too long, goosing the economy into an artificially strong recovery ... with a payoff coming through a substantial uptick in inflation down the road.

With that in mind, CNBC asked me to pull together a list of seven or eight ETFs that stand to benefit from reflationary trends. Here's what I came up with:

Reflation Portfolio/Ideas




Equity (50%)

Vanguard Emerging Markets



Vanguard FTSE All-World Ex-US Small Cap



iShares Global Materials



iShares MSCI Brazil






Commodities (20%)

SPDR Gold Shares



Fixed Income and Currency (30%)

SPDR International TIPS



WisdomTree Dreyfus Emerging Market Currencies



There are a half dozen other ideas I could have mentioned: the iShares TIP ETF (NYSE Arca: TIP); the Vanguard Materials (NYSE Arca: VAW); the Market Vectors Hard Assets Producers (NYSE Arca: HAP); the Rydex CurrencyShares ... etc.

Tim Middleton, MSN Moneycentral columnist, did appear on the segment. He added a nice idea in the ProShares UltraShort 20+ Year Treasury ETF (NYSE Arca: TBT), which delivers -200% of the daily return of 20-year Treasury futures.

As with any "geared" ETF, you have to monitor long-term performance (as we examined in our recent webinar). But it is an interesting play on the reflation idea.

The general outlines of how a reflation portfolio would look are clear. On the equity end, it would focus exclusively overseas to benefit from a falling dollar, and put a particular concentration in emerging markets, which have been leading the economic recovery. It would also focus on materials and materials-heavy economies, such as Brazil.

Broadening out that view, my own "reflation model portfolio" has a strong allocation to gold. While I think gold faces headwinds in the short term, more traction over time for inflation should be good news to bullion investors.

I debated adding a commodity futures ETF, such as the PowerShares DB Commodity Index Fund (NYSE Arca: DBC). But the truth is that broad-based commodities did not perform particularly well during the inflationary period in the 1970s. Oil did well, gold did well, but ags and even industrial metals barely kept pace with inflation.

Turning to fixed income and currencies, I included allocations to international TIPS (NYSE Arca: WIP) and the new WisdomTree emerging markets currencies fund (NYSE Arca: CEW); the latter provides exposure to 11 different emerging market currencies. Emerging market currencies have rallied strongly since the March 9 lows, and the macro factors support their continued strength.

I don't think this should be 100% (or even 50% or 25%) of someone's portfolio. I don't own all these funds myself; my portfolio, as most people know, is boring, long-term focused and ultra-low-cost.

But it does show how investors can use ETFs to make very specific bets ... choices they could NOT have taken advantage of just a few years ago ... to hedge against various economic worries they may have.

If you had tried to buy foreign inflation-protected bonds a few years ago, for instance, most people would have laughed at you. Now you can do it from an E*Trade account for $9.99 and a 50 basis point (0.50%) annual expense ratio.

And that---if you're worried about inflation and a depreciating dollar-is a good thing.

[Editor's Note: An earlier version of this article had the incorrect ticker for the SPDR China ETF. The correct ticker is GXC.]

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Categories : Finance    Themes : Inflation
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