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A Gold-Rated Fund for Broad TIPS Exposure

The best TIPS fund is one that is cheap and that effectively tracks a benchmark that is widely representative of the TIPS market. This fund checks all the boxes.

Treasury Inflation-Protected Securities are bonds issued by the U.S. Treasury Department that have a principal amount that adjusts to reflect observed changes in inflation, thereby protecting investors from the erosion of their purchasing power when inflation exceeds expectations. Nominal Treasury bonds protect against inflation to the extent their yield reflects an inflation risk premium, but their real returns can suffer if inflation runs hotter than expected. A diversified TIPS fund can help protect investors from unexpected inflation.

Schwab U.S. TIPS ETF SCHP is a good choice for exposure to U.S. Treasury Inflation-Linked Bonds. This strategy is tough for active managers to beat because there is limited room for them to recoup their fees without taking additional risk. This fund maintains a cost advantage over most its peers and earns a Morningstar Analyst Rating of Gold. The fund's prospectus net expense ratio (0.05%) is as cheap as it gets, while its tracking error (0.04 from January 2017 through December 2019) is as low as it gets.

This fund tracks the Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index, which includes U.S. TIPS with at least one year until maturity. Holdings are weighted in proportion to their market value (excluding amounts held by the Federal Reserve), which mitigates transaction costs and makes the index easy to track. But it also means that issuing activity can change the fund’s interest-rate risk. Interest-rate risk is the main risk in this portfolio, as its holdings are backed by the credit of the U.S. government and protect against inflation.

TIPS offer a direct hedge against inflation because the principal is linked to the Consumer Price Index, which tracks the prices paid by U.S. consumers in urban areas. The value of the TIPS’ principal is adjusted upward when the CPI rises, which results in higher coupon payments. A TIPS fund will likely outperform a Treasury fund with a similar maturity when inflation exceeds expectations. However, when inflation is lower than expected, a Treasury fund will likely outperform because the market’s expectation for inflation was already baked into its price.

TIPS are issued by the U.S. Treasury Department and carry minimal credit risk. However, this fund takes a fair amount of interest-rate risk, as its duration is 7.70 years, one year longer than the inflation-protected bond Morningstar Category average.

The performance of the strategy from its inception in August 2010 through October 2019 has been solid. During that time, it beat its category average by approximately 36 basis points annually, ranking in the top third of its category.

Process This portfolio replicates the composition of the U.S. TIPS market, effectively harnessing the market's collective wisdom about the relative value of each bond. This is a sound approach because it is cost-effective, it promotes low turnover, and the market does a decent job pricing these bonds. In this market segment there is limited return potential because these bonds are issued by the U.S. Treasury Department, and thus don't contain much credit risk. It earns an Above Average Process Pillar rating.

The fund employs representative sampling to track the performance of the Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index. This index includes fixed-rate U.S. TIPS with at least one year until maturity and $500 million in par value outstanding. Qualifying issues are weighted by market value, but amounts held by the Federal Reserve are deducted from the weighting calculations. This approach tilts the portfolio toward the most liquid issues, which tend to be the easiest to obtain and cheapest to trade. The index is rebalanced once a month, at which time any cash received during the month is reinvested. The fund’s holdings each make coupon payments semiannually.

Because this fund owns TIPS across the maturity spectrum, it takes considerable interest-rate risk. As of October 2019, the fund’s average effective duration was 7.70 years, while the average effective duration of funds in the inflation-protected bond category was 6.50 years. Although this can help performance during periods of falling interest rates, it will likely diminish its effectiveness as a short-term inflation hedge. Long-term interest rates are less directly influenced by changes in short-term inflation than short-term rates.

Risk and return are highly correlated in the fixed-income market, so there is an opportunity cost associated with a TIPS fund because its muted credit risk will likely yield a low inflation-adjusted return over the long run. Moreover, future inflation expectations are already baked into the price of bonds, which means that TIPS will outperform treasury bonds with similar maturity only when actual inflation exceeds expected inflation. The rate at which inflation expectations and actual inflation meet is referred to as the breakeven inflation rate. The 10-year breakeven inflation rate, as of October 2019, is 1.57%, well below the Federal Reserve’s 2% target inflation rate.

Performance The strategy's returns have been strong since its inception in August 2010 through October 2019, beating the category average by 36 basis points, ranking in the category's top third. Although it exhibited slightly greater volatility than the category average, its risk-adjusted performance also placed in the category's top third.

The fund’s holdings have the full backing of the U.S. government and contain virtually zero credit risk. As a result, the amount of interest-rate risk taken in a portfolio is a primary driver of category-relative returns. The trailing 10 years through October 2019 was a period of sustained low interest rates. It makes sense that this fund delivered stronger returns than the category average because it takes more interest-rate risk. During this time the Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index beat the shorter-term Bloomberg Barclays U.S. Treasury Inflation-Protected Securities 0-5 Year Index by 1.74%.

However, when rates rise, this fund could underperform. For example, it underperformed the category average by approximately 78 basis points from August 2016 through December 2016, when the yield on 10-year Treasury bonds increased to 2.55% from 1.55% as inflation expectations grew.

Savvy portfolio management has kept tracking error low. The fund lagged its benchmark by 9 basis points annualized from August 2010 through October 2019.

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