ETF Expert Corner

Northern Trust’s Michael Natale Talks Inflation-Hedging, Spotlights FlexShares ETFs

April 10th, 2018 by ETF Store Staff

Michael Natale, Head of Intermediary Distribution at Northern Trust, discusses growing investor concern over rising inflation and spotlights several FlexShares ETFs that could potentially serve as inflation hedges in a portfolio.



Transcript

You can listen to our interview with Michael Natale by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: Our guest today is Michael Natale, Head of Intermediary Distribution at Northern Trust. They offer the FlexShares lineup of ETFs. They currently have 25 ETFs with over $16 billion invested in those ETFs, and FlexShares has really made a concerted effort to develop ETFs that help investors solve very distinct problems or meet very specific goals. The focus of our conversation today will be on hedging a portfolio for rising inflation, something that is certainly a growing concern for some investors, and FlexShares offers several ETFs that could potentially serve as good inflation hedges. Michael is joining us via phone from Chicago. Michael, great to have you on the program today.

Michael Natale: Good morning, gentlemen. Thanks so much for having me, and congrats on the success of the show. I look forward to hearing it in the future as you all evolve, so thanks for having me.

Nate Geraci: Hey, thank you, Michael. You know, this topic of inflation is receiving a lot more attention recently, and even though inflation is still running below the Fed's 2% target, there's no question this is a growing concern for some investors. I thought to begin here today, do you think inflation should be a concern right now and, if so, why?

Michael Natale: Yeah, Nate, great question, absolutely we do. I think there are arguments that could be made that inflation is being somewhat held down by the government's calculation. Regardless, I think we all can agree that it's on the horizon, and any economist or any advisor that you would speak to will talk to you about the detriments of inflation long-term. I think that it's a great topic for us to talk about today, and as you mentioned earlier, our lineup at FlexShares, and if anybody wants to follow along with us as we go through this, that's flexshares.com, our lineup was specifically designed to hedge against inflation on a short, intermediate and long-term time horizon, so I look forward to this discussion.

Nate Geraci: Michael, before we look at a few FlexShares ETFs that could potentially serve as inflation hedges, I'm curious - how do you think investors should approach hedging a portfolio for inflation? Do you view this as a tactical decision? Should investors always have some long-term exposure to specific inflation hedges? What are some of the considerations here?

Michael Natale: We think it's a strategic decision, but here's the hard part: when inflation is low, it's hard to hedge against something that doesn't seem like it's a concern. But just like buying insurance before the house is on fire is extremely important, we think it's very important to have a strategic allocation to inflation hedging, and that means in, like we mentioned earlier, short, intermediate and long-term, and let me quickly define that. When we think about a short-term hedge, we're thinking in a one-to-five-year scenario. In an intermediate-term space, that's five to 20 years, and in long-term, that's 20-plus years. And I know we're going to talk more about some of the tools that we can utilize to do that, but we really need to break it down into those scenarios because those tools can act differently in different market environments and, as we've seen, just to think about 2017 and now as we go into 2018, in 2017, volatility was historically low. We saw just three days where the market was up plus or minus 1%. We average typically three days a month, and we've already seen that reversion to the mean here in the first quarter and now early into the second quarter where almost every day seems to be a plus or minus 1%. So inflationary pressure, volatility tend to go hand-in-hand.

Nate Geraci: Michael, in the first segment, we talked a little bit about the fact that you don't want your entire portfolio setup to hedge for a particular situation. And so we certainly believe it's important to have inflation hedges in a portfolio, and every investor is going to be different depending upon their specific goals, but just at a broad level, how do investors find the right balance in terms of using inflation hedges on their portfolio?

Michael Natale: Yeah. Thank you, Nate, for that. Let's first talk about ... When we talk about inflation, there's usually two drivers to it. It's either a demand side or the supply side, and so when we have "good inflation," which economists would refer to as that demand driven side, that's where we really need to be careful because that usually comes with economic growth. And that's the environment that we're in right now, and so we want to make good decisions regarding "good inflation". And so the way that we can go about doing that is deploying specific tools to combat those inflationary pressures in those time periods. I hope that answered that question. If I didn't, we can hit it again.

Nate Geraci: No, I think that makes perfect sense, and let's talk about some of the tools. One of the most straightforward ways to hedge against inflation is something called Treasury Inflation-Protected Securities, TIPS, and FlexShares does offer two TIPS ETFs. First, can you just explain how TIPS work for listeners who may be unfamiliar with these?

Michael Natale: Sure, very high level, very basic, TIPS are indexed to inflation in order to protect investors against the negative effects of it. And they're considered extremely low risk because they're backed by the government and, as CPI rises, TIPS come along for the ride. And so you have an investment that is targeted or tied to inflation in that calculation, and so it will move alongside or move along with it to help investors combat inflation.

Nate Geraci: Alright, so the two FlexShares ETFs, the FlexShares iBoxx 3-Year Target Duration TIPS ETF, ticker symbol TDTT, and the FlexShares iBoxx 5-Year Target Duration TIPS ETF, ticker symbol TDTF, both of these hold TIPS, but they're unique in that they target a specific duration. Can you explain what that means and then, perhaps, walk us through why you think that's important?

Michael Natale: Yeah, very important, and you were talking about interesting ticker symbols earlier. Our tickers all make sense at some level, and so I'll explain that, but “TD” is targeted duration, T is TIPS, and then T is three years, and then TDTF is for the five years. So targeted duration TIPS three and five years. Anyway, the reason that the duration exposure is so important is that, when you invest in inflation-protected securities, the major risk is rising interest rates and interest rate risk. And so as you buy a typical TIPS portfolio, which can go from anywhere from zero to 30 years, you are exposed across the board to that interest rate risk, and that is a real negative to what is designed to be a hedge against inflation and to protect purchasing power. So how do we take that potential risk off the table? The way that FlexShares and Northern Trust has done that is by trying to target duration at a three-year and five-year line. And so the reason that's important is that, as you are building a portfolio - because we all know that a TIPS portfolio is not the only part of a portfolio - you need to understand where your duration is. Because when it comes to managing a fixed income portfolio, the major issue in managing fixed income is making sure you get the duration call correct. And, if you could do that right, you can combat the negative impacts of interest rates when you're trying to take advantage of an inflation protection.

Nate Geraci: Michael, if I could just restate that: as interest rates rise, bond prices fall, and so if we get into an environment where both inflation and interest rates are rising at the same time - which wouldn't be abnormal in any way, shape or form - you're going to have the inflation protection with something like TDTT or TDTF, but you're going to have some protection against rising interest rates at least in the sense that you're not going to be as exposed from a duration standpoint as you may be in some other longer duration TIPS products. Is that a pretty simple way to characterize those?

Michael Natale: Very simple, and at FlexShares, we believe that ... Our thesis is that you should be rewarded for every risk that you take, and if you make the right call when it comes to an inflation issue - and, again, we believe it strategically, but we all know that some people enter tactically - when you make that right call, we don't want you to make a mistake on the other end because we haven't planned for a potential risk when it comes to interest rates. So well stated, Nate.

Nate Geraci: Again, we're visiting with Michael Natale, Head of Intermediary Distribution at Northern Trust. Michael, what about the case for commodities right now? Commodities have shown some strength over the past two years or so. They are often viewed as an inflation hedge. FlexShares offers the Morningstar Global Upstream Natural Resources ETF, ticker symbol GUNR. How well do commodities actually combat inflation, and then tell us a little bit about GUNR?

Michael Natale: Yeah. Excellent. When we think about commodities and/or real assets, this is the intermediate-term hedge for inflation. It also is a great diversifier because it leads to a lower correlated asset class inside of an already balanced portfolio. And so where we have seen our clients utilize natural resources is to hedge against that intermediate-term inflation. The hard part is how do you go about doing that? I know that's one of the things we're going to talk about, Nate, is what are the correct instruments to utilize in the real assets and natural resources/commodity space, and so I'm sure that's one of the questions we'll have, so I'll turn it back to you, Nate, and we can talk a little bit about that.

Nate Geraci: Yeah, I guess, first, tell us a little bit about what GUNR does. What does it hold?

Michael Natale: Sure, great question. So GUNR holds equities, and when we think about natural resources, the best way to hold natural resources is to actually hold the commodity, but it's really hard to store. It's very hard to store barrels of oil or bars of gold. But what we want to do is get as close as we can to that natural resource so we can get the benefit of the asset class, which is hedging against inflation and diversifying the portfolio. But here's the hard part: a great way to do that is through futures or forward contracts, but if you're not a trader or you're not looking at those on a daily, even hourly or minute-by-minute basis, it becomes very difficult to manage. What we've seen is that we've seen mutual funds and even ETFs that have deployed these types of products, futures and forward contracts, but because of issues like contango, or backwardation would be wonderful, but because of issues of the contango, where your spot price going forward is more expensive and you tend to not get the call right - so a great point last year is we had, I don't want to get too into the weeds, but we had oil potentially moving north, moving up, and a lot of investors got that call right, but they didn't have the vehicle to get the call right, and ETFs that were investing in futures and forward contracts were actually flat to even negative because of those tough issues when it comes to those instruments. What we did when we designed GUNR was to utilize equities. Now, there's a trade-off there because, Nate, one of the questions that investors will ask is, "Well, I already have exposure to equities." You do, so we wanted to give the benefit of investing in equities, so we decided to align our natural resources product to upstream companies. Those are companies that are on what I would call the left side of the supply chain or closest to the natural resource, rather than down the supply chain or downstream where they're at risk to the adverse effects of erosion through a supply chain.

Nate Geraci: Michael, you began to touch on this, but I want to talk further about this point. One of the pushbacks we've heard to investing in equity-based commodity strategies as opposed to futures-based is that you are obviously taking on that equity risk, right? There are risk factors that can impact these companies, upstream companies, outside of just commodity prices. I'm curious, what are your thoughts on that?

Michael Natale: Yeah, that's a great question, Nate. Here's what I would say. I would say let's take a look at where investors have placed their dollars over a... GUNR has been around for seven years. When you look at the space, our product is the largest in the space, and that's not by accident. It's because of its design, and I think what people and investors have realized is there is overlap when it comes to equities. But the correlation is low enough to make sense, and you can find ways to combat that overlap by taking a look at running analytics to make sure that the portfolio was aligned correctly. Inside of GUNR, there's only 150 to 200 positions, and so when we run it along an otherwise balanced portfolio, the overlap is not as high as you would think. And so, again, there is a trade-off to investing in equities, but we think the trade-off is much better than trying to invest in other avenues through commodities like futures or forward contracts.

Nate Geraci: Michael, just high level, what are some of the categories that GUNR covers?

Michael Natale: Great question. So we're looking at energy. We're looking at, when we think about commodities, agriculture. We're looking at metals and miners. Those are the three main categories. That's 30% each, and then we have two small sleeves in GUNR that are very important, water and timber at 5% each. Timber is an excellent hedge against inflation, and one of the questions we'll get is, "Well, is that that big of a differentiator when you have energy, agriculture, metals and mining making up 90% of the portfolio?" The 5% sleeve into water and timber is a big differentiator, and one of the questions we get is, "Well, why not more into those spaces?" There just simply aren't enough companies to be able to invest more and, hopefully, as that space grows, we'll be able to do that.

Nate Geraci: Again, we're visiting with Michael Natale, Head of Intermediary Distribution at Northern Trust. Michael, lastly, I do want to briefly touch on the FlexShares STOXX Global Broad Infrastructure ETF, ticker symbol NFRA. This holds a global basket of infrastructure companies and infrastructure is interesting because it can be viewed as offering inflation protection - I think especially regulated infrastructure, since pricing is often tied to CPI. Tell us a little bit about NFRA and why it might be a decent inflation hedge.

Michael Natale: Great, Nate, thanks so much. When we think about the long-term hedge, it becomes equities, and equities that are stable. And when you think about infrastructure, that's exactly what those are. If I describe to you all and to your listeners, an entity that had very high barriers to entry, very low competition, great views on future cash flows, pays a nice dividend, a good, steady stream of income, everybody would be asking, "I want to invest in that.". But, sometimes, when they hear the word "infrastructure," people start to say, "Oh, that's a political issue," or it becomes rhetorical because everybody realizes that they want to invest in those facets of the product, but maybe infrastructure scares them away. But here's what I would say: when we think about infrastructure, we're thinking about entities that are very hard to build, and here in Chicagoland, we have toll roads all over the place, and you're going to see someone or another group build a toll road next to another one to take away from that traffic. The other thing you'll notice, when you drive on a toll road wherever you are in the country, very rarely do you pass that toll road and the next time you go on say to yourself, "Well, that's interesting, Nate. That toll was actually higher the last time when I was on it, and now it's lower." That's not the case either. And so what we want to do is provide a long-term hedge against inflation through equities. Infrastructure is a great way to do that.

Nate Geraci: Michael, just high level, how does NFRA compare to some of the other infrastructure ETFs that are out there?

Michael Natale: Yeah, great question. The main part, it's global, so you have a 60% exposure to international companies, 40% domestic, and the other thing is it's more broad and diversified. And so what we tried to do is not just invest in the traditional sectors inside of infrastructure like energy, utilities and transportation, but we also have exposure to communication companies - think cell phone towers and then government and outsourcing in that last super sector. And when you think about government outsourcing, think hospitals, even prisons. They're excellent investments because there's a very high level to competition and to barriers to entry.

Nate Geraci: Michael, we'll have to leave it there. Excellent perspective on hedging for inflation. We certainly appreciate your time today. Thank you.

Michael Natale: Thank you so much for having me, gentlemen. I really enjoyed it.

Nate Geraci: That was Michael Natale, Head of Intermediary Distribution at Northern Trust, and if you would like to learn more about the FlexShares lineup of ETFs, you can do so by visiting flexshares.com.