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ETFs

A TIPS Fund That Keeps a Lid on Interest Rate Risk

This ETF closely reflects immediate shifts in the Consumer Price Index while providing a duration-management feature.

Its short and targeted duration provides a high correlation to immediate inflation changes and reduces unintended interest-rate risk. However, it has a lower yield than its peers, and there are comparable funds at lower costs. It earns a Morningstar Analyst Rating of Bronze.

This fund provides protection against inflation, credit, and interest-rate risk because it only invests in TIPS with between one and 10 years until maturity and backed by the full faith and credit of the U.S. government. The fund’s duration of 2.8 years, as of July 2017, is shorter than the average duration of 7.5 years for the inflation-protected bond Morningstar Category that encompasses the broad TIPS market. To illustrate, if the rate rises by 1 percentage point, this fund would lose approximately 2.8% of its value, while the average TIPS fund would decline by 7.5%.

The fund’s returns are correlated directly to short-term inflation as its principal and distributions evolve with changes in the Consumer Price Index. Gains and losses from the price volatility are mitigated thanks to the fund’s short duration. As a result, this fund more closely tracks the realized inflation fluctuations over the short run than its longer duration counterparts do.

However, the fund’s low volatility and high correlation with the inflation rate come at the cost of low returns. The fund gained 0.04% annually over the five years through July 2017, while its category peers delivered a 0.34% annual loss. Moreover, even though the fund’s management fee of 0.20% is cheaper than most its peers, there are cheaper alternatives.

Fundamental View TIPS are issued with a fixed interest-rate but with a variable principal, which is adjusted based on the two-month delayed CPI figure. The CPI measures the level of prices for a market basket of goods and services that urban consumers buy. The major categories of the goods and services include food, housing, apparel, transportation, medical care, recreation, education, and communication. TIPS apply the fixed rate to the adjusted principal, which changes the semiannual coupon that investors receive.

TIPS may perform better or worse than U.S. Treasuries under different economic scenarios. The current U.S. Treasury yield should reflect the market’s expectation for the future inflation. If the realized inflation is less than the current expectation, Treasuries would offer better real returns than TIPS. But TIPS outperform when the opposite is true. The break-even inflation refers to the rate that would equate the real return from regular U.S. Treasuries and TIPS with the same maturity. As of July 2017, the break-even inflation rate was 1.7% according to the Federal Reserve Bank of St. Louis. It is about 0.3% lower than the 10-year rolling break-even rate average. Any actual inflation exceeding 1.7% would reward TIPS investors, while the opposite would reward U.S. Treasury holders. Per Bureau of Labor Statistics, the inflation rate was 1.6% in June 2017, and the trailing 10-year average was approximately 1.7%. Fed Chairwoman Janet Yellen’s medium-term target inflation rate is 2.0%.

The fund’s target-duration approach gives investors a duration-management tool by maintaining a consistent interest-rate risk profile. The duration of broad market-cap-weighted TIPS funds could change over time, exposing investors to unintended interest-rate risk. For example, if the U.S. government issues large quantities of 30-year TIPS, the duration of those funds would lengthen and vice versa. But, all else being equal, this fund’s duration would be kept at its target.

Given the reduced interest-rate risk, this fund would continue to exhibit a direct relationship with the CPI and inflation changes. The primary source of the fund’s return is the inflation-indexed coupon payments because the short duration minimizes the price volatility. This fund could be a good option for an investor looking for an instrument that closely reflects immediate shifts in CPI and inflation.

But the fund has a low yield. It returned 0.04% annually over the five years through July 2017, still placing it in the category’s top quartile. Its category peers declined 0.34% per year during the same period. On a risk-adjusted basis, measured by the five-year trailing Sharpe ratio, the fund was in line with the category group. Other longer duration TIPS funds offer a higher yield, but with higher volatility and lower responsiveness to the short-run inflation changes.

Portfolio Construction The fund replicates the iBoxx 3-Year Target Duration TIPS Index, which includes inflation-protected U.S. Treasury bonds with maturities between one and 10 years and $2 billion in par value. These constituents are rebalanced monthly and weighted by their market capitalization and durations in order to arrive at the target duration. If the portfolio's duration is above 3.15 years or below 2.85 years, the index will overweight or underweight securities with the longest and shortest durations to bring the overall portfolio duration back to between 2.85 and 3.15 years. It earns a Positive Process rating because it accurately represents its target market, reduces transactions costs with the $2 billion par value limit, and delivers a duration-management mechanism.

Fees This fund receives a Positive Price rating because of its competitive pricing against its category peers. Since inception through June 2017, the fund has lagged its benchmark by 0.15% annually, which is lower than its expense ratio of 0.20%. Compared with the category average of 0.72%, it is offered at an attractive price.

Alternatives

Similar to TDTT,

There is a longer-duration version of TDTT.

The largest ETF in the category,

In the actively managed realm,

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