This Vanguard Fund Offers Inflation Protection at a Low Cost

Key Morningstar Metrics for Vanguard Short-Term Inflation-Protected Securities ETF

• Morningstar Medalist Rating: Gold
• Process Pillar: High
• People Pillar: Above Average
• Parent Pillar: High

Vanguard Short-Term Inflation-Protected Securities ETF VTIP sensibly constructs its portfolio of short-term US Treasury Inflation-Protected Securities and pairs it with a low fee.

The fund tracks the Bloomberg US Treasury Inflation-Protected Securities 0-5 Year Index, which includes TIPS with less than five years until maturity. The index weights holdings by their market value and excludes amounts held by the Federal Reserve to reflect the amount available to the public. The US Treasury issues TIPS, and they carry negligible credit risk as they’re backed by the creditworthiness of the US government. Market-value-weighting is a sensible and efficient approach here as low credit risk and ease of trading leave little room for mispricing.

TIPS offer a hedge against unexpected inflation as their principal amounts are linked to the Consumer Price Index, which tracks prices paid by US consumers. The principal rises when CPI rises, resulting in higher coupon payments. TIPS yield less than Treasuries with a similar maturity by the amount of inflation that the market expects over its duration. As a result, they will likely outperform Treasuries with a similar maturity when actual inflation exceeds the expected inflation that’s baked into their prices. However, when inflation is lower than expected, Treasuries will likely offer higher real return after accounting for inflation.

Targeting short-term TIPS strengthens the fund’s sensitivity to inflation because short-term interest rates move more in lockstep with inflation than longer-term rates. Lower duration keeps the impact of interest-rate risk from overshadowing the inflation protection embedded in their principal adjustments. This provides investors with better inflation protection and lowers the fund’s volatility.

As of September 2024, the fund’s average effective duration of 2.4 years stood on the shorter side of the narrow short-term inflation-protected bond Morningstar Category. Active category peers tend to take on active bets in duration or credit risk to carve out extra returns. Its muted credit risk profile has and should continue to hold up better in credit shocks, such as during March 2020.

TIPS are a narrow sector of the bond market with limited potential for funds to differentiate their performance. Therefore, fees are a critical factor for investors to consider. This fund’s low annual fee of 0.04% lands among the cheapest quintile in its category and should help maintain its performance edge over pricier category peers.

Vanguard Short-Term Inflation-Protected Securities ETF: Performance Highlights

The fund has performed as expected. It eked out 16 basis points annualized in excess return over the category average between its 2012 inception and September 2024. The fund’s low credit and duration risk profile were not well rewarded during the zero-rate environment characterizing most of its existence. More recently, the fund lagged its category average by 41 basis points between May and September 2024. Anticipation around the Fed’s rate cut lowered bond yields across the maturity spectrum in May, a headwind for bonds with lower interest-rate risk.

Nonetheless, the fund has and should continue to offer protection when interest rates and inflation rise. It outpaced the category average by over 2 percentage points in 2022 as rising interest rates and high inflation pushed most asset classes deep into the red. Its inclusion of TIPS with less than a year to maturity also helped it behave more similarly to cash in 2022, which added to returns.

The fund’s muted credit risk profile provided more cushion during credit shocks than its active peers that took on more credit risk. It beat the category average by over 2 percentage points in March 2020 and should continue to outperform when credit spreads widen.

Thanks to its downside protection in these major stress episodes, the fund’s since-inception excess return came with lower volatility. Its risk-adjusted returns (as measured by its Sharpe ratio) were also better than the category average from its inception through September 2024.