When it comes to constructing a portfolio, I used to think it was all about numbers and optimization. When you pick an asset class based on historical data, that assumes you hold through both the good times and the really bad times. It has helped me to keep gathering nuggets of knowledge over time to maintain my faith during those really bad times.

I’d like to start a series of posts to document why I own each specific asset class. Somebody asked me about TIPS the other day, so I’ll start with them. I’m not an investing professional, just a semi-retired DIY investor who wants to keep on learning and would like to share with other like-minded folks. I won’t get into the tiny details, mostly a lot of charts, links, and higher-level ramblings.

Treasury Inflation-Protected Securities (TIPS) are bonds issued by the US government that pay interest which is linked to inflation. Inflation is measured by the Consumer Price Index (CPI). In terms of a useful all-around primer, this Morningstar (M*) article 20 Years In, Have TIPS Delivered? covers a lot of the bases. For more nuts-and-bolts mechanics, see this older Vanguard paper Investing in Treasury Inflation Protected Securities. According to M*, TIPS currently make up about 9% of the overall Treasury market.

Here are my reasons for owning Treasury Inflation-Protected Securities (TIPS):

TIPS are backed by the US Government, just like the more common “vanilla” US Treasury bonds. With bonds, I prefer to stay on the safer end of the spectrum. Bonds are debt, and I don’t want to worry about if I get paid back. Buying US Treasury bonds is the lowest amount of credit risk possible.

TIPS provide a “real” inflation rate at purchase, which means it is guaranteed to provide a set return above inflation (before taxes) until maturity. Very few bonds are structured in this manner. In simplified terms, if the real interest rate is 2% and inflation is 3%, then the total interest paid will be 5%. Working backwards from that, you get the concept of breakeven inflation rate, or the expected inflation by the market (via M*):

The introduction of TIPS brought with it a market-determined observable real rate of interest, which is what the yield on a TIPS is. If you subtract the TIPS yield from the comparable-maturity nominal Treasury yield, you get the market’s inflation expectation over the period until maturity of these two bonds. This is called “breakeven inflation,” because it is the level of inflation at which returns for the nominal and inflation-indexed bonds should break even.

Here’s how the expected inflation and actual inflation compared for 5-year periods since 2003. For the most part, they have been pretty close:

TIPS thus provides insurance against *unexpected* inflation. TIPS are often described as an inflation hedge, but it’s more of a hedge against unexpected inflation. All bonds are already priced with inflation in mind. If everyone thinks inflation will be high, then bonds across the board will be priced to pay out more interest to counter that.

The reason why you don’t hear much about TIPS in the media is that over the last several years, there hasn’t been any unexpected inflation. If you bought fire insurance on your house, and your house hasn’t burned down yet, are you going to stop buying the fire insurance?

TIPS also provides a certain amount of protection in case of severe deflation. TIPS are guaranteed to return par at maturity, meaning they have floor value even in a case of severe deflation. This asymmetry helps make TIPS attractive relative to Treasuries, as best explained by this EconompicData post:

Thus, assuming a view that an inflationary and deflationary scenario are equally likely, the unlimited potential outperformance of TIPS vs. Treasuries in an inflationary environment and limited upside of Treasuries vs. TIPS in a deflation environment would sway an investor towards TIPS.

If inflation meets the market expectations, then TIPS and Treasuries will have the same return. If actual inflation is higher than the (expected) breakeven inflation rate, then TIPS will pay more than the regular Treasury bond. If actual inflation is less than the (expected) breakeven inflation rate, then TIPS will pay less than the regular Treasury bond. Here’s a simple graphic from AAII:

Here’s a 2008-2018 Morningstar chart comparing the growth of $10,000 between the Vanguard Intermediate Treasury Fund (VFITX) and the Vanguard Inflation-Protected Securities Fund (VIPSX). You can see while there is definitely a difference – sometimes one leads, sometimes the other – but over the last 10 years the net return has been very similar. Again, inflation has not been much higher (or a lot lower) than expected.

Do you think future inflation will be higher than the current expected number? Here’s the 5-year breakeven inflation rate for the last couple of years. Via WSJ Daily Shot.

If I had to bet, I would bet that the future inflation number will be higher than 2% then less than 2%. However, most likely they will return around the same amount. So this is not a huge risky bet. In terms of the big picture, it’s a relatively wimpy bet. I currently hold about 1/3rd of my portfolio asset allocation in bonds, and about 1/3rd of those bonds are invested in TIPS. That means about 11% of my total portfolio is in TIPS. If the real yields on TIPS were to go back higher to historical levels, I would go back up to 50% of bonds in TIPS.

Here are some reasons for NOT owning Treasury Inflation-Protected Securities (TIPS).

• TIPS are not part of the efficient frontier. If you run an mean-variance blah-blah-blah optimizer, you won’t find TIPS on the ideal risk/return curve.
• TIPS have a low historical correlation with stocks, but not as low as regular Treasuries – regular Treasuries are a better bet to go up when the stock markets crash.
• TIPS have only been around for 20 years. You might argue that they have not been tested in severe high-inflation environment.
• As with nominal Treasuries, the interest is taxable as ordinary income rates, not the lower dividend or long-term capital gains rates as with stock dividends. You’ll have to pay taxes on this interest every year – it can’t be deferred like if you buy a stock and hold it for a long time. If you buy individual TIPS, you’ll also have to pay income taxes on the inflation adjustment without actually getting the interest until maturity. This is called “phantom income” but can be avoided if you buy TIPS via an ETF or mutual fund. TIPS are thus generally recommended to be kept in tax-sheltered accounts. (TIPS interest is exempt from state and local taxes, however.)
• Some people worry that the government will fudge the CPI numbers if high unexpected inflation really becomes a problem.

If you own bond mutual funds or ETFs, the most popular benchmark is the Bloomberg Barclays Aggregate Bond Index (AGG), which basically tracks all U.S. taxable investment-grade bonds, including US Treasury government bonds, investment-grade corporates, mortgage-backed bonds, and other asset-backed securities. The largest bond fund in the world is the Vanguard Total Bond Market Index Fund (VBMFX/VBTLX/BND), which tracks a slight variation of this index – the Bloomberg Barclays U.S. Aggregate Float Adjusted Bond Index.

In an Advisor Perspectives article, Eric Hickman compares the “Total US Bond” index (AGG) to a Treasury Bond-only index and finds that the overall returns are very similar for both, but Treasury bonds perform better during a market drop. Thus, he concludes that Treasury Bonds Are the Only Bonds You Need.

I wanted to save this chart that lists the returns of both AGG and Treasury bonds during the 10 largest S&P 500 drawdowns since 1976. He points out that 8 out of 10 times (and during all top 6 drawdowns), Treasury bonds outperformed the AGG index.

My personal takeaway was that both Total US and Treasury-Only did pretty well. Right now, AGG has ~42% in US Treasuries and 22% in US government mortgage-backed bonds. If you were a professional advisor or a really detailed DIY investor, then yes, there is an argument for Treasuries only. (Because they are all equally creditworthy, you could even build your own ladder of Treasury bonds with zero expense ratio.) But if you hold a “Total US Bond” fund inside your 401k or target retirement fund, I would still be satisfied that it has historically served its purpose as the safer “ballast” of your portfolio. Overall, I would definitely focus more on keeping your expense ratios low, as the numbers above don’t account for the deduction of fund expenses.

Maybe folks are worried about the yield curve, maybe it’s the political drama, or maybe they just feel it in their bones – I’ve been getting more questions about if I think now is still a good time to invest.

Well, here are some articles that may help you feel better:

What if You Only Invested at Market Peaks? by Ben Carlson. What if you were so unlucky as to invest only at the following market peaks (and suffering the subsequent drops)? As long as you kept on saving your money (putting it in cash when not at a market peak), and not selling at all, you would have actually done fine.

Meet Bob.
Bob is the world’s worst market timer.
What follows is Bob’s tale of terrible timing of his stock purchases.

Should You Invest (Or Wait) When The Stock Market Is At An All-Time-High? at Engaging-Data.com. Here is another interesting interactive tool that lets you pick any subsequent time period and see how the distribution of future returns compared if you invested at an all-time high (ATH) during that period. The market tends to spend a lot of time near all-time highs.

The key takeaway is that in the past several generations of investing, the market has done well and most of the time, the market is within 5% of its ATH. If you waited for a large dip to invest, you could be waiting for a long time and you would have missed out on a large amount of the gains.

Finally, here’s an older post to consider: The Only Two States of Your Portfolio: Happy All-Time High or Sad Drawdown.

I can’t recall the exact source or quote, but I read something along the lines of this in a forum recently:

We don’t really want to hear other people’s opinions. We want to hear our own opinions out of other people’s mouths.

In other words, confirmation bias:

(source: Chainsawsuit.com)

The majority of my portfolio is in low-cost, diversified, passive-managed mutual funds. In order to hear a different take, I read the shareholder letters of Longleaf Partners Funds (Southeastern Asset Management), which are respectable examples of higher-cost, concentrated, actively-managed mutual funds. The managers “eat their own cooking”, meaning they put a substantial portion of their personal net worth into the funds. They have a limited number of holdings, try to avoid asset bloat, and try to outline their positions in shareholder letters.

In their most recent 2nd Quarter 2018 letter [pdf], they share a presentation that explains their position:

Why We Believe Active Long-Term Value Investing in Common Stocks Will Actually Work
Active investing is out of favor; long-term investing (or really, long-term anything) is out of favor; value investing as we practice it is out of favor; and, investing in common stocks is out of favor compared to private equity. Doing all four of these things really makes us the skunk at the party.

Many have given up on active, long-term, engaged value investing in public equities just at the point when we believe it offers the best risk/reward proposition. Indexing’s multi-year momentum has pushed more assets into fewer stocks because they have gone up and left behind an expanding universe of highly competitive, well-governed and managed businesses with unique advantages that are materially underpriced in their publicly traded securities.

They make several interesting points, including the high amount of “closet indexers” out there. (Haven’t there always been a lot of closet indexers though?) I tried to see things from their perspective, but in the end I think their 1% expense ratio is just too high to overcome. It will definitely take a bear market for their performance gap to narrow.

In the meantime, their real problem is that poor relative performance. For every $10,000 invested in their flagship Partners fund 10 years ago, you would have about $18,000 today. If you had put it in a low-cost S&P 500 index fund, you would have about $27,000 today. That’s the difference between 6% and 10% annualized returns over the last 10 years. The extra drag from their ~1% expense ratio accounts for about a quarter of the performance gap.

Longleaf Partners Fund very well might turn things back around. I have no position in any of their funds, but I’ll keep reading their free shareholder letters and watch them try their best to play a very difficult game.