Treasury Inflation-Protection Securities or TIPS are treasury instruments that protect against inflation. Right now, truth be told, they’re not a very popular investment. As investors, we’re a fearful bunch. A crisis in China, a Euro area breakup, a Fed rate hike, an Oil price collapse … the list seems endless.
But has anyone even considered hedging against the most notable evident risk?
Of course, by that I mean inflation. No one fears inflation, so hedging against it isn’t even given a thought. But that’s exactly why you should fear it and should hedge it.
If history is any indication (and it is), inflation always comes. And it comes many times without warning and it is often underestimated.
Hedging against inflation, even when it seems unlikely, is always wise. And TIPS are exactly the hedge needed.
Why TIPS Are a Worthy Hedge
The consensus among investors is that stocks provide the ultimate hedge against inflation. Stock prices tend to keep up with inflation or, in many cases, even beat inflation. But this way of thinking is short-sighted and ignores myriad evidence that suggests this logic is utter nonsense.
Just look at the chart below, which is an historical comparison of the DJIA and the U.S. inflation rate between 1960 and 1990. It shows three substantial inflation cycles (late 1960s, mid-1970s and early 1980s) when inflation outperformed the stock market.
This basically shatters the common belief that stocks are always a hedge against inflation. For full-time protection, you need TIPS, which have a principal that rises or falls in tandem with headline inflation.
When inflation outperforms stocks, the TIPS in your portfolio will outperform, acting as the hedge against inflation. That’s common sense, right?
Hedging with TIPS ETFs
It is possible to directly purchase TIPS, but that tactic requires extreme vigilance. You must be constantly proactive and constantly monitor your bond holdings.
However, there are worthwhile TIPS ETFs that you might want to consider. They provide exposure to TIPS and may do a much better job in protecting against inflation. Here are some TIPS ETFs that are worth owning:
iShares TIPS Bond ETF (TIP) — The largest of the TIP ETFs, by assets. Approximately $13.5 billion in assets held and comprised entirely of TIPS. The TIP ETF holds TIPS across the yield curve, and, according to the Fund’s own report, the TIP average weighted maturity is 8.6 years. That duration makes it a great inflation hedge for the medium range.
Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) — The VTIP is another TIP ETF worth owning. The VTIP ETF holds all its assets in TIPS bonds, as well. However, VTIP’s advantage over the TIP ETF is that the average maturity of its TIPS holdings is 2.6 years. That means VTIP is much better at hedging immediate- or near-term inflation rather than mid-term.
PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (LTPZ) — The LTPZ ETF completes our list of TIPS funds, with exposure to longer term-inflation with an effective maturity of 26 years. The fund holds all its assets in TIPS, with 94% in maturities longer than 20 years. Because of its longer maturities, the fund may be more volatile. However, it compensates for volatility by reacting quicker to an unexpected surge in long term inflation expectations.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.