The Tax-Efficient Anti-Inflation ETF Portfolio for Canadian Investors

Inflation sensitivity ultimately comes down to exposure to the components that feed directly into consumer price inflation. When prices rise across these inputs, inflation prints tend to follow.

Energy, food, metals, building materials, and industrial inputs all show up explicitly or implicitly in CPI baskets, either through headline categories like gasoline and utilities or through second-order effects that ripple through transportation, housing, and manufactured goods.

There are ways to express that exposure directly through futures contracts on oil, gas, metals, or agricultural commodities, but those tools come with structural drawbacks that make them less attractive for long-term investors.

Futures markets often suffer from contango, where contracts rolling forward cost more than spot prices, creating a persistent drag on returns even when commodity prices are flat or rising modestly. Over time, that roll yield can overwhelm the inflation hedge investors were trying to capture.

An alternative is to own the companies that produce, process, and transport these natural resources. Publicly listed producers offer embedded operating leverage to rising prices, meaning earnings can grow faster than the underlying commodity itself as fixed costs are spread over higher revenues.

For Canadian investors, this approach has an added advantage. Domestic sector ETFs (outside of real estate) can be held tax-efficiently in non-registered accounts due to the dividend tax credit, making them useful as a satellite allocation alongside a core stock and bond portfolio.

While there are now multiple all-in-one natural resource ETFs available, it’s also possible to build a simple, targeted solution using just two TSX-listed sector ETFs from iShares in a 50/50 allocation: one focused on energy and the other on materials.

iShares S&P/TSX Capped Energy Index ETF (XEG)

The first 50% allocation in this anti-inflation satellite portfolio goes XEG. Launched in March 2001, XEG is one of the longest-running sector ETFs in Canada and has grown to roughly $1.46 billion in assets under management, making it a sizeable and liquid option for Canadian investors.

XEG tracks 26 companies from the S&P/TSX Capped Energy Index. The “capped” structure limits any single holding to a maximum weight of 25%. That rule matters here because Canada’s energy sector is highly concentrated. Without caps, Canadian Natural Resources and Suncor could dominate the index. Even with the cap in place, those two names still account for close to half of the portfolio, underscoring how top-heavy the Canadian energy market remains.

One important nuance with XEG is what it leaves out. The ETF excludes many energy companies Canadians often associate with income and stability, such as Enbridge, TC Energy, and Pembina Pipeline.

These are midstream businesses focused on pipelines, storage, and transportation. XEG instead concentrates on upstream producers and integrated oil and gas companies.

For an anti-inflation allocation, that bias is actually a feature, not a flaw. Upstream producers tend to have more direct sensitivity to commodity prices, which is where inflation protection shows up most clearly.

That inflation sensitivity has been obvious in past cycles. In 2021, XEG returned 83.78%, followed by another 53.17% gain in 2022 as energy prices surged. The flip side is volatility. In 2020, when oil prices briefly went negative during the early stages of the COVID-19 shock, XEG finished the year down 34.48%. This is not a defensive ETF and should be sized accordingly.

Income is a secondary benefit. XEG currently offers a 3.56% trailing 12-month yield, paid quarterly. Based on 2024 tax reporting, most of that income came from eligible dividends and capital gains, both of which are taxed efficiently for Canadian investors.

The main drawback is cost. XEG charges a 0.61% management expense ratio. That was competitive when the ETF launched more than two decades ago, but it looks expensive by 2025 standards. Despite that, it remains a core revenue generator for iShares Canada, and a fee cut appears unlikely.

iShares S&P/TSX Capped Materials Index ETF (XMA)

The other 50% of this concentrated anti-inflation satellite portfolio goes to XMA, which tracks the S&P/TSX Capped Materials Index and serves as a natural complement to energy exposure.

It is important to note that XMA is not a pure-play mining ETF, even though base metals and gold miners dominate the portfolio due to Canada’s industrial makeup.

The fund also includes fertilizer and agricultural input companies such as Nutrien, as well as forestry and forest products businesses involved in timber and paper. That broader mix gives XMA exposure to multiple inflation-sensitive inputs beyond just metals.

XMA responds to inflation differently than XEG. During the energy-led inflation surge of 2021 and 2022, XMA posted relatively modest returns of 3.43% and 1.25%, respectively. In contrast, it delivered a strong 20.45% return in 2020.

That divergence likely reflects the different drivers at play. In 2020, massive fiscal stimulus, low interest rates, and strong demand from China supported metals and materials, even as energy markets collapsed. The ETF tends to be more sensitive to global growth and construction cycles than to oil price shocks.

Income generation is minimal. XMA currently yields just 0.37%, which makes it even more tax efficient from an income standpoint. In 2024, all distributions were classified as eligible dividends, with no return of capital component.

XMA has been around since 2005 and manages approximately $455 million in assets. Like XEG, it charges a 0.61% management expense ratio. That fee is difficult to justify relative to newer ETFs, but investors seeking pure TSX materials exposure have few alternatives and largely have to accept the cost.