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IPE - Why TIPS Should Still Be Part Of Your Portfolio & How To Invest In TIPS Now

|Includes:SPDR Barclays Capital TIPS ETF (IPE), TIP

TIPS-short for Treasury Inflation-Protected Securities-provide investors with an insurance against the risk of inflation. TIPS are backed by the U.S. government and provide investors with returns that will keep pace with future rates of inflation, as measured by the U.S. Consumer Price Index. You can buy TIPS directly from the government, but it's easier to buy low-fee investment funds that hold TIPS such as SPDR Barclay's IPE, iShares' TIP, or Vanguard's VIPSX.

TIPS enjoyed a remarkably high return in 2011 with the benchmark TIPS index rising 13.56%. Investors have noticed this strong performance. Total assets in TIPS funds jumped 26 percent, or $27.1 billion, in the past year to $131.4 billion at the end of January, according to Lipper.

But we are not advocating TIPS in hopes of soon repeating such unusually lofty returns. In fact the declining yields that drove the majority of the 2011 return are not likely to continue. Yields are currently so low that there is little room for substantial declines (in fact in recent days Treasury yields have suddenly started rising).

We recommend TIPS for the same reason we recommend any asset class - as a single component of a diversified portfolio that will collectively generate the highest possible return for the desired level of risk. TIPS role is to mitigate inflation, while combining with equities, commodities, REITs, cash, and other bonds to maximize return in various market conditions. Allocation to TIPS in our asset allocation models ranges from 5.6% to 15.3% depending on the investor's appetite for risk.

Several things to keep in mind when investing in TIPS:

TIPS and Duration
In this article on Diversifying Bond Duration we explained how all investors should be aware of the duration of their bond investments - and the risk that a rise in interest rates would cause the bond fund's share price to decline.

IPE, the SPDR Barclays TIPS ETF has an average duration of 5.93 years, implying the value of IPE's securities would decline about 5.93% if interest rates rose 1%. The actual loss might be larger or smaller depending on how rates changed in different maturities.

Other big TIPS funds have even longer durations. The $40.8 billion Vanguard VIPSX TIPS fund had an average duration of 8.4 years. The BlackRock Inflation Protected Bond Fund had a duration of 7.8 years at the end of January while the American Century Inflation-Adjusted Bond Fund reported seven years.

As Reuters' Tim McLaughlin explains in yesterday's "Inflation-fighting funds see mounting rate risk": to some extent, longer duration is a feature of TIPS-oriented funds. Duration ultimately measures how long it takes an investor to get the balance of the cash they are owed on a bond including principal and interest. Because a large part of TIPS inflation kicker comes at maturity when the principal is returned, TIPS have a longer duration than the same maturity of ordinary Treasury bond. That helps boost the funds' returns when rates are falling but the advantage disappears if interest rates rise.

TIPS and Fees

SPDR Barclays IPE's annual expense ratio is 0.1845% making it a very efficient way to invest in TIPS. Vanguard's TIPS fund had a 0.22% expense ratio (0.11% for their Admiral Shares), while the average expense ratio for TIPS investment funds is 0.82%.

Far and away the most certain way to control your investment performance is to reduce your investment expense ratios. Even just a 0.60% variation in returns can make a huge difference in your wealth accumulation over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long VIPSX

Stocks: IPE, TIP