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ETF Specialist

For TIPS, Shorter Is Better

This short-duration TIPS ETF offers less interest-rate sensitivity and better inflation protection.

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Thanks to several years of historically low rates, funds like  iShares Barclays TIPS Bond (TIP) have been the most popular exchange-traded way to invest in Treasury Inflation-Protected Securities. However, with rates increasing and subdued inflation expectations, long-duration ETFs like TIP may no longer be the best choice for most investors. Broad TIPS ETFs such as TIP are highly sensitive to interest-rate changes, are a poor inflation hedge, and protect against unexpected inflation over a time period that might be too long for most. Investors worried about rising rates should consider targeting the short end of the curve instead. Shorter-duration TIPS funds are less exposed to interest-rate risk, and are also slightly more correlated to inflation than their longer-dated brethren. Several short-duration TIPS ETFs have emerged in recent years to address these issues, and our favorite is Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), which launched in November last year. This fund has an average duration of just 2.6 years, and its 0.10% annual expense ratio makes it the cheapest way to buy short-duration TIPS bonds. Most TIPS ETFs cost twice as much. Vanguard shifted its target-date funds into VTIP's corresponding mutual fund shares this year, showing the firm’s conviction that short-duration TIPS provide purer protection against inflation. We think VTIP’s cost advantage will give it the edge over other short-duration competitors.

With rates on the rise, investors are increasingly shifting their fixed-income assets into high-quality, shorter-duration bonds. TIPS should be no exception. As is the case with all bonds, rate increases reduce the attractiveness of TIPS bonds already on the market. If new bonds will pay a higher interest rate, why buy the lower rate today? The bond sell-off and increase in long-term rates in the second quarter of 2013 hit TIPS pricing hard, and particularly devastated the iShares Barclays TIPS ETF, which has lost 8.12% in the year to date. Short-dated TIPS, which are less sensitive to rate changes, suffered significantly less. VTIP has lost only 1.76% in the year to date and should continue to outperform relative to TIP if rates maintain their upward climb. This fund is a good fit for investors who have determined that TIPS have a place in their asset allocation and are concerned about interest-rate sensitivity as the Fed begins to end its policy of easy money. On the topic of asset allocation, Christine Benz recently wrote an excellent article about the appropriateness of owning TIPS for different investors.

Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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