ETF Basics: How to Fight Inflation

Tips for TIPS.

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In January 1997, the U.S. government began issuing a new type of bond: Treasury Inflation Protected Securities (TIPS). TIPS are a separate asset class that's distinct from bonds because they behave differently during inflationary times. By owning them, you are further diversifying your portfolio and reducing risk. If you don't own TIPS, you should. At MarketRiders, every retirement portfolio we recommend has at least a 5 percent allocation to TIPS.

Here's why: Regular bonds depreciate in value if there is inflation. If you bought a $100,000 bond that pays 5 percent interest, you'd get your $5,000 per year in interest. But if in three years, bonds were paying 8 percent interest, the bond you owned would be worth less because investors would only have to buy a $62,500 bond to get the same $5,000 yearly payment.

[See ETF Basics: How to Invest in Emerging Markets.]

TIPS protect you from inflation because the amount you get at maturity is adjusted for any inflation that occurred while you owned it. Think of TIPS as a bet with the government. If there is inflation, the government will take the Consumer Price Index and add that to the value of your bond. The coupon interest rate is constant, but it generates a different amount of interest when multiplied by the inflation-adjusted principal, which is how you are protected against inflation. Of course, if there is deflation, then your principal is reduced, but this is a rare economic circumstance. TIPS are offered in five-, 10-, and 30-year maturities.

Here's how TIPS have performed so far: During the past five years, while there has been little to no inflation, TIPS have appreciated about 5.2 percent per year compared with an index of the total bond market, which has returned 6.3 percent. But had there been rampant inflation during the past five years, you'd have been happier owning TIPS.

Here are the only three rational ways to own TIPS:

1. Go through the cumbersome process of purchasing them directly from the U.S. Treasury.

2. Buy a Vanguard index mutual fund. With Vanguard, if you invest $50,000, you can buy the Vanguard Inflation-Protected Securities fund (for only 0.12 percent in annual fees, or a still-low 0.25 percent for smaller investments). Expenses matter because there is no expertise involved in picking TIPS except for buying and maintaining a basket of them, so going with the lowest-cost fund makes sense. But investors seem to flock to such funds as BlackRock's Inflation Protected Bond, for which they pay 1.63 percent in fees—more than the interest paid on the bonds themselves.

[See How to Inflation-Proof Your Portfolio.]

3. Buy a TIPS exchange-traded fund. For most investors, ETFs are the best way to own TIPS. You don't have the hassle and cost of buying mutual funds, you can invest any amount that you wish, and you can buy shares for the cost of buying any stock through your online broker. For years, iShares offered the only ETF with TIPs for 0.20 percent in yearly fees. Recently, State Street issued IPE, which charges 0.18 percent, and Charles Schwab launched SCHP, which charges only 0.14 percent.

Whether you buy a Vanguard fund or an ETF, there is virtually no difference between them except for fees. All hold about 30 to 33 bonds with a similar average duration of five years. So make that bet with the U.S. government and let them pay you for inflation. Put some TIPS in your portfolio and lower your risk.

Mitch Tuchman is CEO and Founder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater piece of mind knowing that they are leveraging the best thinking of Nobel Laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.