Do TIPS ETFs make sense?

By Felix Salmon
August 18, 2009
talking its book when it says that active management makes more sense than indexing if you're buying TIPS. On the other hand, Pimco's arguments are quite compelling -- more compelling, indeed, than counterarguments which don't really address what Pimco says and instead fall back to the standard passive-investing-is-always-better approach.

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It’s quite clear that Pimco is talking its book when it says that active management makes more sense than indexing if you’re buying TIPS. On the other hand, Pimco’s arguments are quite compelling — more compelling, indeed, than counterarguments which don’t really address what Pimco says and instead fall back to the standard passive-investing-is-always-better approach.

The WSJ came to exactly the right conclusion, I think, after looking at the numbers:

Over the past five years iShares Barclays TIPS Bond posted an average annual return of 4.28%, according to Morningstar. That is slightly better than the 4.14% return on the Pimco Real Return fund’s “D” shares, which investors can purchase through a discount brokerage account.

But as always with mutual funds, costs are key. Investors with access to the Pimco funds’ “institutional” shares through a large company retirement plan would have outperformed the ETF, while those in one of the load-paying broker-sold shares classes would have done significantly worse.

I’d only add that it’s crucial, whenever you’re dealing with TIPS, to understand the tax consequences of investing in them — that can make a huge amount of difference, and it’s not uncommon for investors to avoid TIPS entirely just because they can’t deal with the concomitant tax hassle.

As for bond investing, there’s an extra layer of complication here in that it’s very hard to come up with a good index: you can’t just buy-and-hold bonds, as you can with stocks, because that way your duration is constantly declining. As a result, it’s far from clear what constitutes outperforming or underperforming — everything just becomes relative to other investors’ performance.

Still, I’ll stick to the ETFs, just because they’re easier to understand and it’s less likely I’ll be ripped off or subject to some managerial blow-up. My gut feeling is that individual investors are generally foolish to seek outperformance — which is ultimately what Pimco is selling here. And that anybody who can outperform a little can underperform a lot.

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