An Excellent Pure-Play Inflation Hedge

The following is our latest Fund Analyst Report for Vanguard Inflation-Protected Securities 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. The fund's rock-bottom fees provide it with a lower performance hurdle than many peers and contribute to attractive longer-term performance. This, when combined with benefits from Vanguard's strong stewardship, earns the fund a Morningstar Analyst Rating of Gold.

In composition, the fund closely resembles its benchmark, the Bloomberg Barclays U.S. Treasury Inflation Protected Index. However, the team has the ability to add or remove risk relative to the benchmark (typically modest divergences) when it has high conviction about a particular trade, so it is not a true index fund. The team often looks to generate excess return through relative value positioning between bonds and will scale in or out of off-the-run securities when the price is attractive.

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 to nominal Treasuries and provide pure exposure to inflation-hedging U.S. Treasury Inflation-Protected Securities; adding different assets would dilute those effects.

Gemma Wright-Casparius has been sole manager since April 2012, after joining both the firm and this fund in 2011. She brings a wealth of knowledge, with 30-plus years of investment experience, much of it spent in the rates and inflation market. Shareholders have benefited during her tenure: From September 2011 (Wright-Casparius' first full month on the fund) through September 2018, the fund's 1.3% annualized return beat almost 80% of peers.

While TIPS protect against inflation, they are not immune to rate risk. The structure of the TIPS market tilts toward bonds with longer maturities, which increases interest-rate risk relative to intermediate-term bond funds. For example, this fund lost roughly 8.8% between May and August 2013, when rates rose sharply.

Process Pillar: Neutral | Brian Moriarty 11/01/2018 Gemma Wright-Casparius will make modest active bets within this portfolio when opportunities arise, but for the most part, this strategy is run parallel to its benchmark, which underpins a Process Pillar rating of Neutral.

The fund closely tracks its benchmark, the Bloomberg Barclays U.S. Treasury Inflation Protected Index, which makes it similar to index-fund and ETF peers, although the team will make modest bets driven by where it sees relative value. Vanguard's "hub" group, comprising the firm's senior fixed-income leaders, provides Wright-Casparius with a risk budget in the form of a tracking error target, which she can deploy when duration, yield-curve positioning, or attractive break-even rates signal opportunities for return beyond the baseline index. If the team likes an opportunity that would take the fund outside of its hemmed-in risk budget, it must get approval from the hub group.

Much of this process is quantitatively driven. Vanguard has built a variety of in-house inflation models, which the team uses to guide its inflation expectations and to zero in on the places where the risk budget can be put to best use. The fund’s duration will also often be longer than its peers', many of whom keep their duration relatively short to offset the interest-rate risk inherent to the TIPS market. But, given its strategy, the fund carries essentially zero credit risk.

Up to 20% of the fund’s assets can be invested outside of TIPS, but Gemma Wright-Casparius generally does not use that freedom. She says it would detract from the fund’s purpose as a pure play on inflation protection, and she manages within the risk budget set by the hub group. The exception to this is nominal Treasuries, which have ranged as high as 6% in the past. As of September 2018, they accounted for roughly 0.7% of assets, while cash was another 1.9%. The remaining assets were all TIPS, the bulk of which were benchmark securities.

The fund’s duration was 7.4 years, close to the benchmark’s 7.2-year duration but well above the peer median of 6.4 years. The duration on the overall TIPS market decreased slightly over the last year; in September 2017, the fund and benchmark durations were 8.0 and 7.8 years, respectively.

Investors should also be familiar with the mechanics of TIPS. The principal value is adjusted up when inflation rises. The coupon rate is then calculated based on the larger principal amount, 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 (though a deflation floor prevents the fund’s principal from falling below par value at maturity).

Performance Pillar: Positive | Brian Moriarty 11/01/2018 Strong long-term performance continues to earn this fund a Positive Performance Pillar rating.

From September 2011 (the first full month of Gemma Wright-Casparius’ tenure) through September 2018, the fund’s 1.3% annualized return landed in the top quartile of distinct inflation-protected bond fund peers. Rock-bottom fees provide a lower performance hurdle than many peers, and subsequently, the fund remains competitive even with a more hemmed-in risk budget than many peers over time.

The fund’s long duration compared with peers (7.4 years versus 6.4 years) will have an impact on its relative performance during interest-rate sell-offs. For example, the fund’s 8.8% loss between May and August 2013 (the taper tantrum) lagged 80% of peers. More recently, it lagged 70% of peers between August and December 2016, when rates rose during the U.S. election season. That dynamic can be amplified by peers’ tendency to hold inflation hedges like REITs, high-yield bonds, and commodities, which are less sensitive to rates than TIPS.

Those same portfolio differences also expose competitors to significantly more credit risk, and during credit sell-offs this fund will often outperform. During the energy-driven sell-off between September and December 2014, and again from June 2015 through February 2016, this fund held up better than 90% of peers.

People Pillar: Positive | Brian Moriarty 11/01/2018 The manager's depth of experience, combined with Vanguard's broader fixed-income resources, earn the fund a People Pillar rating of Positive.

Gemma Wright-Casparius joined Vanguard in 2011 after many years spent managing a global inflation-linked portfolio for Singapore’s sovereign wealth fund. She was named on this fund in August 2011 and became sole manager in April 2012 after longtime manager John Hollyer moved into a risk-management role. Hollyer is now Vanguard’s global head of fixed income. Wright-Casparius has more than 30 years of investment experience, much of it spent in the inflation and rate markets.

She is directly supported on this offering by a small cohort that includes one trader, one quantitative analyst, and one strategy analyst. But the broader support available is impressive. That includes a larger quantitative analyst team, access to the firm’s 30-plus corporate credit analysts, and Vanguard’s Investment Strategy Group, which operates the team’s inflation models and is roughly 50 strong. The firm’s senior strategy group, called the hub, also touches this fund through its oversight of the risk budget. That group includes head of fixed income John Hollyer, head of rates Ron Reardon, and head of risk Rodney Comegys, among others.

Parent Pillar: Positive | 06/05/2018 The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar: Positive | Brian Moriarty 11/01/2018 The Price Pillar rating is Positive because this is one of the cheapest options available among both open-end mutual funds and exchange-traded funds 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. All three share classes charge below-average fees, excluding the impact of certain investment-related expenses.

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