Vanguard Inflation-Protected Securities Is a Top Pick

The following is our latest Fund Analyst Report for Vanguard Inflation-Protected Securities Fund VAIPX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

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.

Performance Pillar: Positive | Brian Moriarty 11/08/2016 The fund has performed well for investors over the long term. As of October 2016, it ranked in the top 25% of the category over the trailing 10 years and in the top 19% over the trailing five years. It lost 1.8% in 2015, which was a difficult year for the category due to deflationary fears caused by a slowdown in China and huge drop in oil prices. However, it held up better than peers, which had a median loss of 2% for the year. The category has rebounded so far in 2016, due to fears of increasing inflation. Rates at the long end of the yield curve also fell for most of the year, which benefited the category as TIPS funds tend to have a long duration. The fund's year-to-date return was 6.9% as of October, which outpaced 75% of peers. Given the fund's strong long-term record, it earns a Performance Pillar rating of Positive.

One point of concern for some investors is the fund’s relatively long duration, 8.3 years as of September 2016. This means that if interest rates rise 1%, the fund would lose roughly 8.3%. If the Federal Reserve raises rates by the expected 0.25%, this represents a 2% loss for the fund. However, this assumes a parallel shift in the yield curve, which is unlikely, so the fund’s losses are not guaranteed. Furthermore, a pickup in inflation around the same time as rising rates would help to offset losses from interest-rate risk.

People Pillar: Positive | Brian Moriarty 11/08/2016 Gemma Wright-Casparius joined Vanguard in 2011 after three decades of experience working on a global inflation-linked portfolio for Singapore's sovereign wealth fund. She became this fund's lead manager in April 2012 after longtime manager John Hollyer moved into a risk management role (now heading that group). Another previous manager, Ken Volpert, moved into a senior position in 2011 as global head of fixed-income indexing. Their positions give them a measure of influence over the fund and provide continuity.

Wright-Casparius is supported by the firm’s interest-rate satellite team, as well as two traders and a quantitative analyst who constructs the models which optimize the fund’s portfolio according to the strategy. The team may be small, but the process lends itself to a small team and she can leverage Vanguard’s resources and strengths.

Vanguard’s senior strategy group, called the "hub," sets the fund's overall strategy. The team is composed of head of fixed income Greg Davis; head of tax-exempt fixed income Chris Alwine; risk specialist John Hollyer; and chief economist Joseph Davis; as well as Paul Jakubowski, who provides a credit perspective, and Ron Reardon, who represents the interest-rate team.

Parent Pillar: Positive | 11/02/2016 Vanguard has one of the mutual fund industry's strongest corporate cultures and earns a Positive Parent rating. Its consistent messages to investors to keep costs low, diversify, and stay the course are reflected in the firm's own behavior. Vanguard's U.S. fundholders own the firm through small investments by each mutual fund, mitigating potential conflicts of interest that can exist at other firms that are serving two masters. Fund performance is strong overall: Over the past three-, five-, and 10-year periods, its Morningstar Success Ratios are greater than 70%--high among large, diversified fund families.

Over the past year, the firm has collected more than USD 200 billion in net inflows, thanks in large part to investors’ interest in passive investing. The firm's indexing and ETF prowess, low costs, and success in penetrating the financial-advisor sales channel all have fueled growth. Total assets under management now exceed USD 3.3 trillion, giving Vanguard a significant more-than-20% market share across U.S. mutual funds.

Vanguard has been a global player for years but has only more recently turned its focus to growing internationally. The firm is a large player in Australia, where it has the most history, but doesn't yet have the brand recognition and trust it enjoys in the United States in other parts of the world. Nevertheless, while non-U.S. funds don't participate in the ownership of Vanguard, the firm's investor-centric culture extends globally.

Price Pillar

: Positive | Brian Moriarty 11/08/2016

The Price Pillar is Positive because this is one of the cheapest options available among both open-end mutual funds and ETFs within the inflation-protected bond category. The Admiral share class charges a 0.10% expense ratio, while the Investor share class carries a 0.20% expense ratio. The only cheaper funds available are institutional share classes with very high minimum investments, or ETFs. Some ETFs cost as much as the Investor share class, such as