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Vanguard Inflation-Protected Securities Is a Top Pick

This low-cost Gold-rated fund is a pure-play inflation hedge.

Morningstar, 11/20/2016

Vanguard Inflation-Protected Securities is an excellent choice for investors looking for a pure-play inflation hedge. Its fees are among the lowest for open-end mutual funds and exchange-traded funds; it has excellent long-term performance; and it benefits from Vanguard’s strong stewardship. For these reasons, it earns a Morningstar Analyst Rating of Gold. 

Gemma Wright-Casparius took over as lead portfolio manager in April 2012, maintaining the fund’s long-standing process--and that’s a good thing. The fund stays close to its benchmark, the Barclays US Treasury US Tips Index, and lets its low fees contribute to returns. However, Wright-Casparius has the ability to add or remove risk relative to the benchmark when her team has high conviction about a particular trade, so it is not a true index fund. 

Unlike many funds in the inflation-protected bond Morningstar Category, this one does not court additional risk by looking for extra sources of return in commodities, high-yield bonds, or other assets. The fund is meant to act as a diversifier from nominal Treasuries and as pure exposure to an inflation hedge, and adding different assets would dilute those effects. This also brings the fund more in line with ETFs, which have pure benchmark exposure. 

One thing to be aware of with most funds that invest in Treasury Inflation-Protected Securities is that their duration can run longer than a comparable nominal bond fund, especially with many active managers shortening their duration in anticipation of rate hikes. This holds true for this fund, which has an 8.3-year duration, making it highly sensitive to changes in interest rates.

Process Pillar: Neutral | Brian Moriarty 11/08/2016 
The fund tracks its benchmark closely, which makes it similar to index fund and ETF peers, though managers here may make small active bets. Vanguard’s “hub” group gives manager Gemma Wright-Casparius a risk budget for three major factors, relative to the benchmark: duration, curve position, and the breakeven rate. The fund’s positioning is driven by the relationship between the benchmark and this risk budget. Wright-Casparius and her team are responsible for security selection, and try to add value through small bets if they think certain durations or positions on the yield curve are over- or undervalued. If the team likes an opportunity that would take the fund outside of its risk budget, they must get approval from the hub group.

The team recently built an internal model of real-time inflation, which is updated regularly and helped the team add value through several relative value trades in 2016. Relative to the benchmark, the fund is slightly long on duration (8.3 years versus 8.1 years for the index). It also has a long bias to breakeven rates and the fund should do well if the breakeven rate rises, which has been the case so far this year. Because the fund is managed very close to its benchmark, and the manager only makes small active bets relative to that benchmark, it carries a Process Pillar rating of Neutral.

Up to 20% of assets can be invested outside of TIPS, but Wright-Casparius generally does not use that freedom for two reasons. First, she says it would detract from the fund’s purpose as a pure play on inflation protection. Second, she manages within the risk budget set by the hub group. The exception to this is nominal Treasuries. While there aren’t any in the fund as of the most recent portfolio, allocation has ranged as high as 6% in the past. As of October 2016, the fund held every bond in its benchmark Bloomberg Barclays U.S. Treasury Inflation Protected Index, as well as some out-of-benchmark TIPS to give it more exposure to breakeven rates. The average peer only had about 60% of assets in TIPS, with the rest in a variety of other assets.

The fund invests primarily in TIPS issued by the U.S. government. A TIPS’ principal value is adjusted up when inflation rises. The coupon rate is then calculated based on the increased principal, increasing the dollar value of the coupon payment. However, the reverse is also true: When inflation falls, so does the principal value of the bond and the dollar value of the coupon payment. The nature of these up and down adjustments make TIPS more volatile than nominal bond funds. For example, this fund has been almost twice as volatile as the Barclays US Aggregate Bond Index over all standard trailing time periods, as of October 2016.

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