Tips for Choosing a TIPS Fund

Eric Jacobson: When it comes to choosing a TIPS fund, the story is a little paradoxical. That's because getting your arms around the underlying mechanics and movements of TIPS bonds can be pretty complex and daunting, but picking among TIPS mutual funds is actually pretty easy.

That's because TIPS are a lot like conventional Treasury bonds, which are very uniform and don't cost a lot to trade. And even though TIPS aren't as liquid as conventional Treasuries, they are pretty easy to trade compared with most other kinds of bonds. And in the case of TIPS, there are actually only 40 of them, and they average roughly $35 billion in issuance per bond. All in all, TIPS markets are pretty efficient overall, and managers running portfolios that are limited to TIPS generally have a hard time distinguishing themselves from one another without taking on an unusual amount of risk.

As a result, there are really only two ways to go if you want to be a standout TIPS offering. One is to supplement TIPS with additional market exposures to help add excess returns and distinguish yourself from plain-vanilla competitors and index funds. The other is to run portfolios close to or in line with indexes and charge as little as possible.

And when you look at favorite TIPS funds among Morningstar analysts, that split is pretty evident. The funds that our analysts rate most highly tend to either have very low expense ratios or have proven they can produce better returns than TIPS index offerings by taking on some--but not excessive--extra risk.

Two of our most highly rated picks are run by Vanguard. One is Vanguard Inflation Protected Securities, and the other is Vanguard Short-Term Inflation-Protected Securities Index Fund. Schwab offers a TIPS ETF that only charges 5 basis points and also gets one of our highest ratings.

On the other end of the spectrum is PIMCO Real Return. That fund charges well more than the average plain-vanilla or index offering, but it isn't overly expensive at the end of the day and benefits by supplementing a basic TIPS portfolio with other PIMCO bets designed to give the fund a leg up.

All in all, there are roughly 60 different TIPS funds out there, but only a handful really deserve your attention.

(Disclosure: Eric Jacobson owns shares in PRRIX, a different share class of PIMCO Real Return.)