Try This Approach To TIPS ETFs

If inflows to exchange-traded funds holding Treasury Inflation-Protected Securities (TIPS) are an accurate indication, investors are comfortable betting inflation is on the rise.

The renewed boom in exchange-traded funds holding Treasury Inflation-Protected Securities (TIPS) confirms investors and money managers are betting that inflation might just be an issue the Fed is not paying enough attention to.

The Importance Of TIPS

In fact, TIPS ETFs are an important complement to fixed income portfolios because many passively managed aggregate bond ETFs do not hold these types of bonds.

The Vanguard Short Term Inflation Protected Securities ETF (Vanguard Asset Allocation Fund (NASDAQ:VTIP)) is one avenue investors can consider for TIPS exposure. The $2.2 billion VTIP holds just 16 bonds, but the real source of allure here for investors concerned about interest rates is the ETF's average duration of just 2.7 years.

Related Link: Inflation Busting With ETFs

Short-term TIPS funds like this one can be attractive because they are a purer play on the realized month-to-month changes in the CPI. This means they will see gains when CPI goes up, but also experience losses when CPI goes down. Their short duration reduces interest-rate risk and the volatility that goes with it. With reduced volatility and increased exposure to actual changes in inflation, short-term funds like this are as close to a pure inflation hedge as investors can get, said Morningstar in a recent note.

When it comes to yield, TIP and rival treasury inflation protection securities (TIPS) ETFs are not going to wow anyone. That is true of VTIP, which does not feature a yield, but with realized inflation and inflation expectations on the rise, this ETF and its brethren merit further attention.

Looking Closer At VTIP

VTIP is getting that attention, as highlighted by year-to-date inflows of nearly $168 million. Of course, part of investors' enthusiasm for this ETF is that, like other Vanguard funds, VTIP is inexpensive. With an annual fee of just 0.08 percent, or $8 for every $10,000 invested, VTIP is less expensive than 89 percent of rival funds, according to Vanguard data.

Buying TIPS after inflation has gone up means it has already been priced in and investors are possibly overpaying for their TIPS exposure. In addition, nominal interest rates tend to rise along with inflation because investors will demand a greater yield to compensate for the risk and generate positive real returns. Rising rates negatively affect TIPS just like nominal bonds, and this loss could cancel out the inflation-hedging benefit, added Morningstar.