From the October 2006 issue of Wealth Manager Web • Subscribe!

Standing Guard

With drivers grumbling about gasoline costs and the consumer price index (CPI) climbing, this could be an intriguing time to consider inflation-protected funds. These funds mainly invest in Treasury Inflation-Protected Securities (TIPS). The inflation-protected funds could be particularly attractive, since they suffered a downturn during the first five months of 2006 when they lost 2.0 percent. That may have left TIPS at bargain levels.

When TIPS first appeared a decade ago, academics hailed them as ideal vehicles for protecting nest eggs against inflation. While investments such as precious metals generally climb during periods of rising prices, TIPS provide a superior cushion because their principal value moves in lockstep with the CPI. Say an investor puts $1,000 into an inflation-protected bond, and inflation rises 4 percent during the next year. The principal value of the security will climb to $1,040.

Besides enjoying rising principal, a TIPS holder also gets a fixed yield, such as 3 percent. That yield stays constant throughout the life of the bond, but the interest payments are based on a principal value that may rise every year. The rising principal value helps to make TIPS among the most stable bonds around. So why did the inflation funds lose money recently? Rising interest rates caused the red ink. When rates rise, bond prices typically weaken, and TIPS are no exception.

With the Federal Reserve raising rates earlier this year, yields paid by 10-year TIPS rose from less than 2.0 percent in January to more than 2.40 percent in May. In August, the Federal Reserve paused in its campaign to raise rates. The pause could signal that rates have peaked. If rates do stabilize, TIPS investors could enjoy a calm period of steady returns.

One way to judge whether TIPS are selling at bargain levels is to consider the so-called breakeven inflation rate. If inflation exceeds this level, TIPS will outperform conventional Treasuries. The current yield of conventional 10-year Treasuries is 5.01 percent. The current yield of 10-year TIPS is 2.41 percent; because their principal can rise, TIPS typically yield less than other Treasuries. By subtracting the TIPS yield from the Treasury yield, you derive the current breakeven level--2.60 percent. In effect, the market is suggesting that inflation will average the breakeven rate for the next decade. If that happened, TIPS and comparable Treasuries would produce similar returns. But lately, the CPI has been climbing at an annual rate of 4.3 percent. If that figure persists, TIPS would outdo conventional Treasuries by a wide margin.

Even if inflation stays below the breakeven rate, TIPS can still be worthwhile as diversifiers. Inflation funds often rise when stocks fall. That occurred in 2002 when the Standard & Poor's 500-stock index dropped more than 22 percent, and inflation funds returned 14.3 percent. TIPS can also diversify bond portfolios. In 1999, inflation funds returned 1.4 percent, while the Lehman Brothers Aggregate bond index suffered a loss.

Which inflation-protected fund makes the best choice? To find a winner, we turned again to screens developed by Donald Trone, chief executive officer of Fiduciary360, a consulting firm in Sewickley, Pa. Trone's due diligence process seeks funds that are at least three years old and have more than $75 million in assets. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens narrowed the field from 112 contenders to 6 finalists. The fund with the top five-year returns was FFTW U.S. Inflation-Indexed Portfolio, but we eliminated that choice because it is designed for institutions. Other strong performers were American Century Inflation-Adjusted Bond and T. Rowe Price Inflation-Protected Bond. Finally we selected Vanguard Inflation-Protected Securities, which had the highest Sharpe ratio and five-year returns of any retail-oriented finalist.

Vanguard won the title by sticking to the basics. While some competitors buy corporate and foreign securities, Vanguard focuses on plain-vanilla U.S. government securities. Portfolio managers John Hollyer and Ken Volpert aim to beat the TIPS benchmark by 30 or 40 basis points a year. To accomplish that, they overweight maturities that seem like bargains.

Volpert says that the fund often picks up a few basis points by taking advantage of bond auctions. "When an auction occurs, new supplies come on the market, and prices often get a bit cheaper," he explains. "That presents a buying opportunity."

During July, the government auctioned 20-year TIPS. In anticipation of the flood of supply, Vanguard underweighted 20-year bonds several weeks before the auction. Then around the time of the new issue, the fund began buying, since prices had dropped. After the auction, the market gradually digested the new supply and prices rose back to normal levels, producing small gains for Vanguard.

The fund managers also make small bets on interest rates. When rates seem likely to rise, the managers may buy somewhat shorter maturities. Short bonds tend to suffer relatively small losses during periods of rising rates. "When the Federal Reserve was raising rates, we shortened up the portfolio," says Volpert. "Now we are lengthening because the Fed seems about finished with raising rates."

Perhaps the fund's biggest edge is the kind of rock-bottom expense ratio that the Vanguard Group has long provided. While the average inflation fund charges an annual expense ratio of 1.76 percent, according to Morningstar, Vanguard Inflation-Protected Securities only charges 0.20 percent. In the low-yielding bond markets, few competitors can overcome Vanguard's expense advantage.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a business writer and regular contributor to Wealth Manager.

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