Looking a little closer at the historical correlation between inflation and the returns of these funds, we see that the relationship is not as linear as investors might expect.

When inflation is high and rising, that does not mean that an inflation-linked fund or index will automatically rise; the opposite is often true. What matters more when it comes to these inflation-linked ETFs is not inflation today, but rather what is expected to happen to inflation in the months, quarters, and years ahead.

“This is an area where the relationship seems simple and obvious: why not buy them if inflation is rising? It depends on what the market expects to happen,” says Eric Jacobson, fixed-income strategist at Morningstar.

“If the market has already priced in the current rise in inflation and does not expect further increases in the future, the value of bonds linked to the cost of living will not benefit.”

The Best EUR Inflation-Linked ETFs

There are today 5 Europe-domiciled inflation-linked bond ETFs provided by iShares, Amundi, Xtrackers and UBS. All of them earn a Morningstar Medalist Rating of Gold, Silver or Bronze. In such a universe there are limited opportunities to add value over a standard index-tracking approach in a consistent manner, and so this places low-cost passive funds in a good position to deliver above-average returns over the long term.

The iShares € Inflation Linked Government Bond UCITS ETF IBCI is by far the largest ETF of its category and the only one with assets under management exceeding £1 billion. This fund fell 0.07% over the past year, lagging behind its benchmark, the Morningstar Eurozone Treasury Inflation-Linked Securities Index, by 0.14 percentage points. Year to date, the iShares fund rose 2.04%.

At the same time, the Amundi Euro Government Inflation-Linked Bond UCITS ETF E15H lost 0.06% over the past year, but less than the average fund in the EUR inflation-linked bond category, which fell 0.11%. The fund placed in the 50th percentile for performance and lagged its benchmark by 0.13 percentage points. This ETF has gained 2.44% year to date, while the average fund in its category is up 2.61%.

The Xtrackers II Eurozone Inflation-Linked Bond UCITS ETF XEIN fell 0.07% over the past year, leaving it in the 51st percentile for performance. The fund lagged the Morningstar Eurozone Treasury Inflation-Linked Securities Index by 0.14 percentage points. Year to date, the Xtrackers fund rose 2.36%.

The passively managed USBBG Euro Inflation Linked 1-10 UCITS ETF FRC3 gained 1.91% over the past year, outperforming the average fund in the EUR inflation-linked bond category, which fell 0.11%. The fund placed in the fifth percentile for performance and beat its benchmark by 1.84 percentage points. This ETF has gained 3.36% year to date, while the average fund in its category rose 2.61%.

Due to its longer portfolio duration, over the past year the USBBG Euro Inflation Linked 10+ UCITS ETF FRC4 fell 4.89%, while the average EUR inflation-linked bond fund lost 0.11%. The fund placed in the 100th percentile for performance and lagged the Morningstar Eurozone Treasury Inflation-Linked Securities Index by 4.96 percentage points. The fund has climbed 0.03% year to date, underperforming the average fund in its category, which rose 2.61%.

How Inflation-Linked Bond ETFs Work

Inflation-indexed bonds contractually link the principal and interest of the bonds to a nationally, regionally, or globally recognized measure of inflation. This type of bond is typically issued by a national government and offers periodic coupons and redemption at maturity, both of which are linked to inflation rates.

However, investors in a fund or ETF are exposed to the market value of the bonds in the portfolio. Among other factors, interest rates determine this value. Like any other bond asset, inflation-linked bonds are subject to the relationship between duration (the sensitivity of a bond to interest rate changes) and interest rates, except that in this case it is real rates that matter (rather than nominal rates). The real interest rate is the interest rate net of the current inflation rate.

Should I Invest in Inflation-Linked Bond ETFs?

According to Dan Sotiroff, senior manager research analyst for Morningstar Research Services, these bonds have a very specific use case for investors.

“First, they’re bonds, so you should be thinking here of like capital preservation. You want to shield your money from some big risk out there, like a market crash or something like that,” he says.

“Then, it really gets down to inflation expectations. These bonds shield against unexpected inflation and the emphasis really needs to be on the unexpected component. If you think that inflation is going to be higher than what the expectations are today, then you would go into an inflation-linked bond versus like a regular Treasury.”

At the same time, Mara Dobrescu, fixed-income strategies research director at Morningstar, believes that “investors should be aware that these products have their own distinct mechanisms,” as “inflation-linked bond funds, especially in the Eurozone and the UK, are usually issued with longer maturities than plain government bonds. This means that they tend to have a much longer duration, on average, than their nominal bond counterparts, making them much more sensitive to interest rate changes.”

That is why “investors must assess whether they consider it more important to protect their portfolio from rising inflation or rising interest rates (since choosing an inflation-linked bond fund with a long duration could compromise this second objective). Secondly, when choosing an inflation-linked bond fund, it is essential to examine the fees, as low-fee products have the best chance of success in the long term,” says Dobrescu.