Are investors hedging against inflation with TIPS?

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Are investors hedging against inflation with TIPS?

Consumer prices were widely expected to increase in 2021, but many investors were rattled when inflation soared to a 40-year high of 7% during the year. 

How are investors attempting to deal with inflation in their portfolios? Two of our investment strategists, Tom De Luca and Paulo Costa, looked at the portfolios of roughly 7 million self-directed Vanguard clients to see if they were using Treasury Inflation-Protected Securities (TIPS) mutual funds and ETFs to hedge against inflation in 2021. 

Observations and tips on TIPS

Our strategists’ research confirmed what they had expected—that Vanguard’s retail clients with taxable or IRA accounts had increased their direct investment in TIPS funds in 2021. “At a granular level, the data showed that investors’ holdings directly through TIPS funds increased substantially in 2021 compared with before the inflationary shock in 2019 and 2020,” De Luca said. 

At the same time, investors’ overall allocation to TIPS, which comes largely through target-date funds (TDFs), was about the same as before. “Despite the increase in the direct holdings of TIPS funds, most investors with TIPS exposure still get it through TDFs, and that number didn’t change much. And on average, investors’ TIPS allocations still fell short of the levels suggested by Vanguard’s TDF glide path.” 

(Note that while a glide path is a reasonable place to start, it’s based solely on age and not on other factors important to investors, such as investment objectives, personal risk tolerance, time horizon, or other inflation-fighting assets they may hold.) 

Here are the key findings of the research:

• The number of retirement-age investors with direct holdings in TIPS funds increased from the two previous years but remained modest. 

For that age category (62 and older), the percentage of TIPS holders climbed to a range of 4%–5% in 2021 from levels closer to 3%–4% in the two previous years, presumably as investors sought to offset the potential loss of purchasing power on the interest income from nominal bonds, which tend to make up a substantial portion of their portfolios. 

Having a TIPS allocation in place before inflation rises is key. Inflation expectations are factored into the price of both nominal Treasuries and TIPS, so the value of holding TIPS in a portfolio is largely for the protection they offer from unexpected increases in inflation.

“The modest change in investors’ overall allocation to TIPS in 2021 suggests they do not see inflation as a long-term concern,” Costa said, “but that could change as the inflation shock unfolds. It’s something we will continue monitoring closely.” 

 

With inflation soaring, retirement-age investors in particular added TIPS funds to their portfolios 

Note: Includes all Vanguard retail investors (taxable and IRA accounts).
Source: Vanguard, as of December 31, 2021.

• A much greater number of investors get TIPS exposure indirectly through the autopilot feature in TDFs, a point illustrated in the chart below. Many of these funds (which include Vanguard TDFs and those of other TDF providers held in Vanguard client accounts) add TIPS as investors age, which is consistent with life-cycle models of investing.
  

Naturally, investors get higher allocations to TIPS by investing directly in TIPS funds. However, more Vanguard clients get exposure to TIPS in their portfolios through TDFs—which happen to include inflation protection but probably were not purchased only for that express purpose.

More investors get inflation protection indirectly through TDFs than directly through TIPS

Note: Includes all Vanguard retail investors (taxable and IRA accounts).
Source: Vanguard, using fund allocation to inflation-protected securities as defined by Morningstar, as of December 31, 2021.

 

Many investors may not have optimal levels of TIPS in their portfolios.

The chart below suggests that investors who hold TIPS directly in their portfolios generally hold similar allocations, regardless of age. Older investors in this category have an allocation to TIPS as a percentage of fixed income securities in their portfolios that falls roughly in line with the level targeted by Vanguard’s TDF glide path, while investors in their 50s appear to have an overweight exposure.

TDF investors, on the other hand, see their exposure to TIPS increase with age. Those aged 62 and above would therefore have had inflation protection in place before the recent surge in prices made the need for it abundantly clear.

The level of inflation protection in those same investors’ portfolios nevertheless is below the level targeted by Vanguard’s TDF glide path. Owning investments in addition to TDFs that do not carry inflation protection is a likely cause of the shortfall, underscoring how important it is for investors to look at all their holdings as one investment portfolio.

Investors tend to be over- or under-allocated to TIPS compared with our TDF glide path

 

Note: Includes all Vanguard retail investors (taxable and IRA accounts).

Source: Vanguard, as of December 31, 2021.

 

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.