RLY ETF: Still a Good Idea (NYSEARCA:RLY)

Since we’ve written about the SPDR SSGA Multi-Asset Real Return ETF before (NYSE:RLY) Inflation has cooled significantly.Is inflation fully under control and should we sell RLY, or will inflation remain an issue in the coming years? Is it worth investing in a real asset ETF like RLY?

We don’t think inflation will average as low as 2% over the next few years, so investing in a diversified and actively managed real return ETF like RLY remains a smart idea. Diversification can reduce risk, and active management can also be helpful, as not all inflation-hedged investments will work as expected given historical inflation betas.

Has inflation disappeared?

We witnessed a sharp decline in inflation from 9.1% in June 2022 to 3.7% in August.

On the other hand, although inflation If the current inflation cycle continues to develop along the lines of the inflation cycle of the 1970s, then the cooling of inflation data in the past few months cannot rule out a new rise in inflation data in the next few years…

Truflation provides a daily updated “big data” inflation indicator. It uses a dynamic and transparent approach that responds to global market conditions faster than monthly updated Consumer Price Index (CPI) data. The so-called “inflation rate” dropped to 2% but is now close to 3% again.

Bloomberg columnist Mohamed El-Erian recently discussed the possibility that “a sustained slowdown in inflation would become trapped in the 3% to 4% range, sustainably above the Fed’s 2% inflation target and keep the market interest rate structure at Higher levels “longer”.

Deglobalization, decarbonization and demographics are pushing inflation numbers higher than they have been over the past decade. We also don’t expect inflation to average as low as 2% over the next few years, and we wouldn’t be surprised if the Fed raised its inflation target to 3% or 4%. This would make them less constrained than the current 2% inflation target and may help avoid a (severe) recession. In 2012, Federal Reserve Chairman Bernanke set a target inflation rate of 2%. Prior to this, the Fed did not have a clear inflation target.

In 2020, the Federal Reserve revised its long-term goals and monetary policy strategy statement. The Fed’s goal is for long-term inflation to average 2%. In practice, this means that, after a period in which inflation has been consistently below 2% as it has been in previous years, appropriate monetary policy will allow inflation to remain above 2% for some time.

Since the 2020 revision, longer-term inflation expectations have been revised up from 2% to 3%.

Note that Invesco no longer talks about the Fed’s 2% target, but instead talks about the Fed’s comfort zone of 2% to 3%….

If inflation stays above 2%: Real Return ETFs are still a good idea. Let’s take a look at how real return assets perform.

Performance

The assets with the highest inflation betas and correlations with inflation are commodities and natural resources, followed by infrastructure, REITs and inflation-protected bonds.

Over the past 12 months, stocks and commodities (including gold) were the best-performing asset classes. Treasuries, TIPS, and REITs were the worst performers as (real) interest rates rose.

The poor performance of TIPS (and REITs) is striking.

Inflation causes interest rates to rise, which causes bond prices to fall. TIPS were considered an inflation hedge, but that didn’t work. TIPS are Treasury securities whose principal value is indexed to inflation. When inflation rises, the principal value of TIPS increases as (CPI) inflation rises. Coupon payments are based on a percentage of the (adjusted) principal, so when inflation rises, TIPS investors receive higher coupons.

Therefore, the TIPS yield is a “real” interest rate because it reflects the real (or real) increase in the purchasing power of the investment and takes into account the effects of inflation.

The problem with TIPS is that they are not simply bets on inflation. TIPS are made up of two parts, which can confuse how TIPS move through the interest rate cycle. There is a direct inflation-related component, but there is also a fixed income component. The fact that the fixed income component can move in the opposite direction of inflation is what makes making money on small interest-protected bonds so difficult.

Just like “ordinary” nominal bonds, TIPS are bonds. When nominal bond yields rise, nominal bond values ​​fall; when real bond yields rise, nominal bond values ​​fall. The price of TIPS will adjust as inflation rises, but if real interest rates rise, the impact of the inflation adjustment may not be enough to offset the loss from rising real interest rates.

As of the end of 2021, the 10-year (nominal) Treasury yield was 1.52%. The (real) TIPS yield is -1.04%, so the breakeven inflation rate is 2.56%. At the same time, nominal interest rates rose to 4.25%, while real interest rates rose to 1.9%.

So while nominal interest rates increased by 2.73%, real interest rates increased by 2.94%! Rising yields cause bond prices to fall. Inflation adjustments have supported inflation-protected bonds, which have performed slightly better than nominal bonds even though real yields have risen more than nominal yields.

Owning TIPS in an inflationary environment is no easy win.

But because (real) TIPS rates have increased significantly, the long-term expected returns on TIPS are now significantly higher.

Additionally, certain equity sectors are hedged against inflation: energy, real estate investment trusts, and metals and mining are among the best performing equity sectors in an inflationary environment. All three are included in RLY.

While energy has certainly performed well, the same cannot be said for REITs.

The best-performing stock sector was Oil & Gas Equipment & Services. Additionally, the metals and mining sectors also performed well.

We’re pleased to see sectors we’ve written about before appearing among the top performers: Oil & Gas Equipment & Services, Homebuilders, and Metals & Mining.

Now, let’s take a closer look at the building blocks of RLY.

RLY

RLY is an actively managed ETF currently overweight natural resources (agriculture, energy, metals and mining), infrastructure, cash and commodities.

RLY underweight TIPS and real estate.

We like this active management approach and the stance taken by the fund manager. We are bullish on commodities, although we prefer the iShares S&P GSCI Commodity Index Trust (GSG) to the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF, PDBC.

We are not very optimistic about real estate.

The SPDR S&P Global Infrastructure ETF (GII), the fund’s second-largest position, remains a drag on RLY’s overall performance. GII invests in the transportation, utilities and energy infrastructure sub-sectors. GII was the only overweight position that underperformed. The portfolio manager remains optimistic on global natural resource stocks and infrastructure stocks as they “will benefit from secular trends in infrastructure spending as well as decarbonization and other green energy themes.”

RLY uses a proprietary risk sentiment indicator (Market Institutional Indicator). The indicator uses a quantitative framework and forward-looking market indicators, including equity and currency implied volatility and credit spreads, to identify the current market risk environment. Tracking changes in risk appetite over market cycles can help develop tactical asset allocation and volatility targets.

At the end of June, the indicator showed less risk aversion, which is why the fund became more aggressive and reduced its cash position to 4%. Currently, the cash position has increased again to 5.6%.

Global infrastructure, REITs and TIPS remain in a long-term downward trend.

Energy, metals and mining stocks remain in a long-term uptrend, as does RLY itself.

in conclusion

Excluding infrastructure, RLY’s overweight positions have outperformed, while underweight positions have underperformed. Active management is paying off, and as a result, RLY is in a long-term upward trend.

We don’t think inflation will average as low as 2% over the next few years, so investing in a diversified and actively managed real return ETF like RLY remains a smart idea.