A Fine Inflation Hedge From Vanguard

The following is our latest Fund Analyst Report for Vanguard Inflation-Protected Secs Adm VAIPX

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Vanguard Inflation-Protected Securities provides a straightforward inflation hedge with an attractive price tag. Under our new ratings methodology, its cheaper share classes receive a Morningstar Analyst Rating downgrade to Silver from Gold, while its most expensive receives a Bronze. This careful investment effort has been under the sole auspices of experienced manager Gemma Wright-Casparius since April 2012. She joined the firm (and this strategy's roster) in 2011 and has nearly 40 years of investment experience, much of it spent in the rates and inflation-linked markets. Though the team directly supporting her is small, she's also backed by the firm's hub of senior fixed-income leaders, a broader group of rates specialists, and ample quantitative research and risk-management resources. As a baseline, the team keeps this strategy close to the Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index. Unlike some competitors in the inflation-protected bond Morningstar Category, this strategy does not court risk beyond U.S. government-backed sectors. Instead, Wright-Casparius sticks with Treasury Inflation-Protected Securities and nominal Treasuries on the margin, deviating modestly from the benchmark when she has high conviction in a trade. For example, the portfolio will scale in or out of off-the-run TIPS as their relative value fluctuates. Wright-Casparius' vigilance and the strategy's low fees have benefited investors over her tenure. From September 2011 through July 2020, the Admiral share class' 2.7% annualized return surpassed more than 75% of distinct rivals and roughly matched its benchmark's. Yet this strategy is not without risks. The structure of the TIPS market tilts toward bonds with longer maturities, as reflected by the portfolio's 7.9-year duration, which makes this and similar TIPS strategies vulnerable during periods of rising yields. And in the wake of plummeting yields in 2020, this strategy's SEC yield stood at negative 1.0% as of July 31, 2020, illustrating a punishing cost for inflation protection. Process | Average Despite an ability to make moderate active bets within the portfolio where opportunities arise, lead manager Gemma Wright-Casparius rarely strays far from the strategy's benchmark. It can be challenging for straight-laced active strategies to consistently gain an edge over the index in this constrained market, supporting an Average Process rating. Vanguard's "hub" group, comprising the firm's senior fixed-income leaders, provides Wright-Casparius with a tracking error target, which she can deploy when duration, yield-curve positioning, or attractive break-even rates signal opportunities beyond the baseline Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index. The hub group must approve any opportunity she wishes to take outside its constrained risk budget. Vanguard has built a variety of in-house inflation models that the team uses to guide its inflation expectations and zero in on opportunities. Deviations from the benchmark are typically modest. While the strategy's duration stays within range of the index's, the presence of strategies tracking short-duration TIPS indexes in the peer group means its sensitivity to changes in real yields is a bit higher than the category average. But given its focus on U.S. TIPS and to a lesser extent nominal Treasuries, the strategy doesn't court credit risk, unlike some rivals who venture into credit sectors. People | Above Average An experienced and thoughtful manager supported by Vanguard's expansive fixed-income resources earn the strategy an Above Average People Pillar rating. 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 tight cohort comprising two traders (one senior and one junior) and two quantitative analysts (also senior and junior). But her broader supporting apparatus is impressive. That includes access to a larger quant analyst team 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 Sara Devereux (who replaced previous head Ron Reardon late in 2019), and head of risk Manish Nagar, among others. Parent | High The Vanguard Group entered a new era in early 2019 with the passing of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its USD 5.6 trillion in global assets under management, as of June 2019, are in the United States; but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico. Vanguard gained its stature by following Bogle's playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That's enriched Vanguard's investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard's passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate. Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019 it disclosed plans to launch a digital-only counterpart. Vanguard's industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom. Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar category's cheapest quintile. Based on our assessment of the fund's People, Process, and Parent pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Silver. Performance From September 2011 (the first full month of Gemma Wright-Casparius' tenure) through July 2020, the Admiral shares' 2.7% annualized return landed in the top quartile of distinct inflation-protected bond category peers. Rock-bottom fees provide a lower performance hurdle than many rivals, and subsequently, the strategy remains competitive even with a more hemmed-in risk budget than many peers over time. The strategy's long duration compared with that of its typical peer (7.8 years versus 6.9 years as of June 2020) will have an impact on its relative performance during interest-rate sell-offs. For example, its 8.8% drop between the May-August 2013 taper tantrum lagged 80% of peers. More recently, it lagged 60% of rivals over the first 10 months of 2018, when the U.S. Federal Reserve hiked interest rates. That dynamic can be amplified by some peers' tendency to venture into credit-sensitive bond sectors, and even a few that take risk in more volatile areas such as high-yield bonds and commodities, which are less sensitive to rates than TIPS. Those same portfolio differences also expose competitors to more credit risk, and during credit sell-offs this strategy has often outperformed. When credit markets collapsed because of the coronavirus pandemic between Feb. 20 and March 23, 2020, this strategy's 0.6% loss was less severe than 75% of its cohort. Portfolio As of June 2020, this strategy was nearly 100% invested in TIPS. As inflation rises, the principal value of TIPS adjusts upward. 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 strategy's principal from falling below par value at maturity). Up to 20% of the fund's assets can be invested outside of TIPS, but internal limits are much stricter. Gemma Wright-Casparius argues that non-TIPS exposure would detract from the strategy'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 the team will purchase when their pricing and yields are attractive relative to TIPS. Though the strategy held zero nominal Treasuries as of June 2020, this exposure reached close to 3% in November 2019 and again in May 2020. The bulk of the strategy's TIPS holdings consisted of benchmark securities. The strategy's duration sat at 7.8 years as of June 2020, longer than the benchmark's 7.3-year duration and well above the typical inflation-protected bond category peer's 6.9-year duration.