TIP: Is There a Better Inflation-Proof Bond ETF?

Earlier this month, InvestmentNews released a list of the ten ETFs financial advisors researched the most in 2009. The list, which was based on information provided by Morningstar, included several traditional inflation hedges, such as the SPDR Gold Trust (GLD) and iShares COMEX Gold Trust (IAU), as well as the broad-based PowerShares DB Commodity Fund (DBC). And in the top spot was the Barclays TIPS Bond Fund (TIP), which invests in inflation-protected securities issued by the U.S. Treasury.

TIP has seen its popularity surge over the last year, taking in nearly $9 billion in cash in 2009. This trend has continued in 2010; fund has already seen inflows of more than $1.5 billion through the first two months of the year. Clearly, investors are concerned about inflation. And clearly, many think they’ve found the solution in the form of inflation-protected bonds. But those investors who are counting on TIP to protect their portfolio may be set up for a colossal disappointment.

TIP certainly isn’t a flawed product. Far from it, in fact. It accomplishes its stated objective–tracking the performance of the Barclays Capital U.S. Treasury Inflation Protected Securities Index–with impressive efficiency. The expense ratio of 20 basis points is one of the lowest for any fixed income ETF. But investors terrified over the prospect of a spike in inflation who think they’ve found a Holy Grail might have a false sense of security. TIPS are a good place to start, but they have some inherent limitations–particularly within the exchange-traded structure–that may diminish their ability to protect against inflation.

The Case for Inflation Protection

For the last 25 years, inflation has been moderate, generally hovering between 1% and 4%. But the U.S. has experienced surges in inflation before, most recently during the late 1970s and early 1980s when CPI peaked above 15%. While economists are divided over exactly what causes inflation and hyperinflation, many academic studies have uncovered a strong link between CPI and money supply. In the wake of massive injections of liquidity to the financial systems in the U.S. and around the world, many investors believe that higher inflation is inevitable and that hyperinflation is entirely possible. Wary of the ramifications for traditional stock and bond portfolios when the bill for the recent stimulus plans comes due, investors have begun seeking out protection.

Treasury Inflation-Protected Securities (TIPS) are debt issued by the U.S. government. Unlike most Treasuries, the principal of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, the noteholder is paid the adjusted principal or the original principal, whichever is greater. TIPS make interest payments twice per year. Because the interest rate is applied to an adjusted principal amount, the interest payments made will rise and fall with inflation.

So conceptually, the appeal of holding these bonds in an inflationary (or hyperinflationary) environment is easy to grasp. TIP is a good start for investors anxious over the prospect of runaway inflation, but for several reasons it might not be the silver bullet some investors think it is:

3. TIPS Have Never Been Tested

While it’s obviously impossible to extract individual investor motives with any precision, it seems likely that a fair number of investors in TIP aren’t worried about inflation that tests the high end of the Fed’s “comfort zone,” but rather about hyperinflation reminiscent of 1973 or 1981 that breaks into double digits. TIPS were first introduced in 1997, meaning that they have endured a relatively stable CPI trajectory since their inception and have never been tested in a high in a true high-inflation environment.

The fact that TIPS have a relatively short history obviously isn’t sufficient reason to steer clear. But it’s certainly worth noting. Perhaps greater cause for concern is the correlation of TIPS to inflation in recent years. The following table displays the quarterly correlation of various asset class returns to U.S. inflation between January 2002 and March 2009 (click to enlarge image):

This doesn’t mean that inflation isn’t a driver of TIPS performance, but rather that these securities are impacted more significantly by other factors, including changes in interest rates. “The moves in TIPS have little to do with the actual fluctuations in the CPI,” wrote Dave Nadig recently. “That’s not because they’re broken; it’s simply that movements in the bond market have historically dwarfed movements in CPI.”

2. TIP Includes Long-Term Bonds

This statement is an obvious one, but it’s also one to which that many investors likely haven’t given enough thought. When considering the underlying holdings of TIP–inflation protected bonds–it’s easy to focus on the first two words, without considering the ramifications of the third. In a recent article for Index Universe, Matt Hougan suspected that some investors may not know what they’re getting themselves into. “What they don’t realize is that the Federal Reserve will likely raise interest rates well before significant inflation is captured in the official CPI,” writes Hougan. “That means TIPS investors will likely feel the pain of rising rates before they feel any benefit from CPI-related inflation adjustments.”

TIP has an effective duration of 3.9, and about 25% of the fund’s holdings have at least 15 years remaining to maturity. As such, TIP is potentially vulnerable to rate hikes–much more so than short-term bond ETFs (SHV, for example, has an effective duration under 0.4). If inflation and interest rates head higher in unison, TIP may play the part of the second of the Three Little Pigs in the hyperinflation tale–it’s nice the house isn’t made of straw, but the end result might not be much different.

1. TIP Reacts to Market Expectations

By purchasing a single inflation-protected security from the U.S. government and holding it to maturity, an investor can guarantee himself or herself a real return above changes in the Consumer Price Index. That’s a surefire way to protect against inflation. But TIP isn’t a single security; rather it’s a fund comprised of about 30 different notes. And the price and yield of TIP are determined not by the prevailing level of inflation, but by supply and demand among investors. As such, it’s important to note that TIP is often impacted more by investor expectations of CPI than it is of actual CPI.

The last year serves as a perfect example. Over this period–a period of extremely low inflation–TIP has delivered a return of about 9%. The iShares Barclays 3-7 Year Treasury Bond Fund (IEI), which maintains comparable duration and maturity to TIP, gained less than 1% over the same period, a performance gap of more than 8%.

Demand for TIPS has surged over the last year, resulting in a significant run-up in the price of TIP. This example provides anecdotal support for the numbers presented in the table above, and highlights some of the complexities that may arise when investing in TIPS through an ETF.

CPI: A Better Inflation-Proof ETF?

Historically, investors have turned to a variety of securities to hedge against inflation, including short-term bonds, gold, and other commodities now available through ETFs (See Beyond TIP: 10 ETFs To Protect Against Inflation). But recent innovation in the ETF industry has expanded the options for combating inflation beyond traditional “plain vanilla” asset classes traditionally used by investors. One relatively new offering is the IQ CPI Inflation Hedged ETF (CPI), a fund that seeks to provide a hedge against inflation by providing a real return above the rate of inflation as measured by the Consumer Price Index.

CPI is designed to track the performance of the IQ CPI Inflation Hedged Index, a rules-based benchmark that utilizes the monthly change in the Consumer Price Index on a rolling 12-month basis to determine holdings.

The index underlying CPI is designed to achieve exposure to asset classes whose returns incorporate inflation expectations, based on the premise that capital markets tend to be forward-looking in nature and anticipate economic developments (including changes in inflation).

Currently, CPI’s holdings are dominated by short-term bonds (through SHV and BIL), but the fund has the latitude to invest in a variety of asset classes, including domestic and international equities, currencies, commodities, and real estate. While the fund’s core position will generally include a significant allocation to short-term bonds, the establishment of satellite positions in other assets creates the opportunity to generate real return in excess of inflation.

CPI is a relatively new fund, meaning that similar to TIP, it’s never been tested during a period of hyperinflation. But the more active approach to beating inflation is based on mountains of historical data, correlation analyses, and some sound yet simple investment principles.

If you’re really concerned about inflation, CPI might be worth a closer look.

Disclosure: No positions at time of writing.