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Inflation Protection: When TIPS Aren't Enough

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

With the Federal Reserve's latest round of quantitative easing, some investors have grown concern that inflation could spike. I recently sat down with Chris Philips, who is a senior analyst in Vanguard's Investment Strategy Group, to discuss the best ways to inflation-protect a portfolio.

Chris, thank you so much for being here.

Chris Philips: My pleasure.

Benz: One hot topic recently, especially with QE3 under way, is this question of inflation and how big a bite it could take out of portfolio returns.

First, one question I'd like to tackle is, you have said that inflation should be sort of a customized target based on my own spending basket. Let's talk a little bit about that, and how I should think about that question.

Philips: I think the challenge we all face is that we see inflation-linked vehicles out there--TIPS are the most popular vehicle out there. But the government reported CPI rate, which TIPS are linked to, might not be relevant for everyone in every stage of their life, and yet that's what the inflation-fighting vehicles are measured against.

So, if you are a retiree, for example, you might have health-care costs that at least for the last memorable history, have been increasing much faster than CPI. If you have a disproportionate amount of your expenses in food or energy, which tend to be very volatile, they can be much greater than CPI, they can be much less than CPI. These are factors that we would want to consider when thinking about the impact of inflation on us as citizens, but also our investment portfolio and our ability to meet future obligations, whether it's education, health-care costs, or just the cost of living.

Benz: You mentioned health care and education. Those are two areas that have been running hotter than the general inflation rate. If those are big shares of my overall expenditures, how do I think about actually getting a higher rate of inflation protection? Where do I go for that?

Philips: So, this … gets down to time horizon. So … if someone is starting a 529 plan, for example, and they have a one-, two-, or three-year-old child, and the 529 is out for 18, 19, 20 years in the future, then we would actually look at equities as probably your best vehicle for giving you positive real returns, giving you returns above inflation over that time period. If we were to, say, put all that money into TIPS, yes it's going to track CPI over time, but you might not actually get enough money to fund a child's education because of the low returns you get in a traditional sense.

So, we actually do view equities as being a vehicle where investors that have longer time horizons can hope to pick up that inflation premium, if you will, over the CPI rate.

Benz: And the higher inflation that retirees can expect mainly because they may have higher health-care outlays, you would also say argues for holding equities in a retiree's portfolio.

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Philips: We do. And if we just look at a generic portfolio, and I'll point to our target retirement income portfolio--and you would see this across not just Vanguard, but other providers as well--there is usually an allocation to equities in those income portfolios. It's not going to be a significant allocation, but it's going to be there, and it's going to provide some of that cushion for the prospect that we have even just moderate, drip, drip, drip inflation. If you have just very low-risk assets in [the portfolio], that [inflation] is going to eat away your ability. And again if you have health-care costs that are not 3%, but maybe 6% or 7% year-over-year growth, then you need something that is going to give you a little bit extra potential return in that portfolio.

Benz: Chris, you mentioned, TIPS--Treasury Inflation Protected Securities. Vanguard just launched a short duration exchange-traded fund focused on that space. Let's talk about the thesis behind that product, and why and where it could possibly make sense in a portfolio?

Philips: So, … our current fund [Vanguard Inflation Protected Securities] basically represents the TIPS market, so all the bonds that are out there, both long-term, intermediate term, and short-term bonds out there.

The challenge that we've always had with just the broad market of TIPS is that it comes with a very significant amount of [interest rate] risk. The duration, so to speak, is very, very high, and that's because the Treasury tends to issue 30-year, 20-year TIPS, which, they have that very long horizon, but they are very sensitive to changes in interest rates.

Well, for someone who has an objective of tracking inflation, having a lot of volatility because of interest rate changes, detracts from the ability to actually track inflation.

So, our idea was, if you can actually bucket the shorter end of the vast maturity spectrum of all those TIPS, hopefully you'd be able to track inflation more tightly. That was the general idea behind it. It is designed for investors who--again, there's no free lunch, so you have lower return expectations because the lower risk--but it should track that CPI rate more closely from month-to-month, year-to-year than something that has a much more expansive interest rate exposure.

Benz: One other question related to TIPS is, I think retirees especially wrestle with how large a piece of their portfolio a TIPS allocation should be. So they know that those nominal bonds' payouts will be eroded over time by inflation. How big a hedge should they put in in the form of TIPS? Do you have any guidance to share on that topic?

Philips: So I think there are actually two things here. First, we constantly remind people that, if your inflation rate is equivalent to CPI, then TIPS can make a lot of sense, but they also only make sense, and you are only protected from inflation, if 100% of your portfolio is in TIPS. Because if you run into inflation, only the portion that's in TIPS is actually going to be insulated from that inflation. The rest of it is still going to be exposed in some respect. So, we always want to keep that in the back of our mind.

But as I said earlier, we also noticed that every investor has a different personal inflation rate. So, we also want to have some mixture of assets in the portfolio, because at the end of the day, we do believe that the Fed has some credibility, and that moderate inflation is their target. They will do everything they can to prevent super-inflation, or deflation like we've seen in Japan. If that's the case, then traditional nominal assets should do OK. So, we don't want to have a significant portion in TIPS. Again, I'll point to our Target Retirement Income Fund, where by the time someone retires, we end up with around 20% of the portfolio in TIPS, and the remainder split between equities and traditional nominal bonds.

Benz: OK, Chris. Thank you so much for sharing your insights on inflation.

Philips: You are very welcome.