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How to Hedge Your Portfolio With ETFs

Last week I was deep into research for the July issue of Sector ETF Trader when I was taking a moment to gather my thoughts. I turned my attention from my computer to the television. As usual, it was tuned onto CNBC. I turned up the volume and started listening to the talking heads.

And much to my surprise, there was a coherent and articulate debate on the money supply and inflation.

The Kudlow Report was hosting two economists. One is sure we’re headed for high inflation, while ETFs to Reduce Downside Volatility the other contends inflation doesn’t pose a threat at all.

These contradictory viewpoints make investment choices difficult to say the least. The smart money is hedging their portfolios against the downside presented by either side of this argument.

Here’s what you need to know.

The economist decrying inflation gave this simple example, “… if you have a huge increase in the supply of apples, the price of apples falls.” Applying this argument to the monetary base means an increase in the supply of money decreases the dollars purchasing power, which is inflationary.

The other economist countered with, “If people suddenly want to hoard apples and the apple suppliers provide a lot of apples, you’re not going to have inflation of apple prices.” The argument here is banks are hoarding the money instead of lending it. Hoarding money doesn’t increase the money circulating in the system, which isn’t inflationary.

Who’s right?

Let’s start with the facts. The monetary base has grown by a jaw dropping $858 billion in the last year. At the same time, the amount of excess reserves on bank’s balance sheets grew by $842 billion.

Most of the increased money supply is sitting on the sidelines. As long as it sits there, it’s not going to cause inflation. But when banks start lending again, watch out. It’s a proverbial powder keg.

The only way the Fed can keep inflation from exploding is by reducing the money supply.

But here’s the problem. The Fed is stuck between a rock and a hard place. In order for the Fed to remove this excess money supply, it would need to sell $800 billion worth of treasuries. And that’s in addition to the $3+ trillion they’re already on the hook to sell in 2009.

If the Fed dumps an additional $800 billion in treasuries, it will drive up interest rates. This will be a huge blow to the economy. I don’t see them sacrificing economic recovery to keep inflation in check.

So what does all of this mean to your investing strategy?

The risks favor a high rate of inflation over the next 3 to 5 years. But there’s always the possibility the Fed will remember its true purpose and decide to preserve the purchasing power of the dollar. If it does, the world economy could enter a prolonged period of little or no growth.

You can do a few things now to hedge your portfolio against either inflation or stagnant growth.

The oldest and best way to hedge against inflation is gold. If you don’t already own some, now’s the time to buy. Remember, you’re not investing in gold to get rich, you’re trying to avoid going broke. The SPDR Gold Shares ETF (GLD) provides an easy way to add gold to your portfolio.

Hedging against stagnant growth gets a bit trickier. In my opinion, non-cyclical companies paying a nice dividend are the best way to go. In particular, I like the utilities because of their steady revenue and dividend payments.

There are a host of different ETFs focusing on the utilities sector. The Vanguard Utilities ETF (VPU) is a good choice. VPU has a small (even by ETF standards) expense ratio of 0.25% while paying a 4.52% dividend yield.

The inflation debate will continue on. In a perfect world, economic growth will return and the Fed will pull the money supply out just right so we don’t have high rates of inflation. But I’m not willing to go for broke. Hedge your portfolio now against a less than perfect economic recovery.

Corey Williams is the co-editor of the Dynamic Wealth Report, a free investment newsletter that offers investment ideas and news you can’t get from the mainstream investment press. Corey and his team bring decades of Wall Street and Silicon Valley experience to help you discover profitable trading ideas you can use today.

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