A friend who sometimes solicits my advice on investing matters -- for anonymity's sake, we'll call him "Dad" -- often floats trial balloons my way about potential tweaks in his portfolio.

After checking his quarterly statement the other day, this friend said he was considering lightening up on the Vanguard TIPS fund I recommended, which happened to be the worst performer among the stock and bond funds he owns this past quarter.

"But Dad," I said, "If the stock market retrenches, you are going to love that TIPS fund because it offers a hedge against inflation as well as a great diversification tool against equities. In many down quarters, it will probably end up the best performer in your portfolio." I spared him my usual discourse on how excessive tinkering with one's portfolio based on short-term performance is one of the most damaging things an investor can do, and stuck with the following explanation of how TIPS work and why they serve the dual function of being a safe investment and a great portfolio diversifier.

How They Work

In January 1997, as the mutual fund industry was trudging out a slew of Internet funds to lure performance chasers, the U.S. Treasury offered investors one of the best financial tools since the dividend about 400 years ago: Treasury Inflation Protected Securities, or TIPS. Unlike traditional bonds, TIPS adjust their principal and interest payments over time in response to changes in inflation.

So let's say you purchased a TIPS with a fixed interest rate of 3% with a $1,000 face value. If the consumer price index, the key inflation gauge, rose 2.5% next year, the face value would increase to $1,025 -- and the interest payment would increase as well.

In essence, TIPS surmount the bane of a cautious fixed-income investor's existence: inflation. While deflation is on Federal Reserve Chairman Alan Greenspan's radar screen, it rarely occurs and remains unlikely now. (By the way, the Treasury Department built a safeguard against deflation into the system: The final payment to individuals cannot be less than the TIPS original face value.)

A Few, Er, Pointers on TIPS

Investors have a decent number of options when it comes to buying TIPS, and the one that works best for them depends on a few factors -- including tax matters.

First, you can buy them directly through the Treasury Department. The agency sells TIPS in $1,000 increments at auctions in January, April, July and October -- it even has a Web site that sells them. Individuals can also purchase them at any time through a broker, where fees may come into play. The recent 10-year TIPS auction has a 1.875% fixed interest rate. When you own TIPS, you receive interest payments every six months and a payment of principal when the security matures. Individuals can also purchase a TIPS mutual fund, such as the ( VIPSX) Vanguard Inflation-Protected Securities fund.

What are the pros and cons of each option? In some areas, buying TIPS directly gets the edge. First off, you don't need diversification when buying TIPS or other federal government securities, neutralizing a key benefit of mutual funds: diversification. Also, direct purchases are cheaper. Vanguard's TIPS fund carries a tiny 0.22% expense ratio, but it's still 0.22% more than buying TIPS directly.

A big upside of a TIPS mutual fund for investors (like my friend) is that they're much easier to get ahold of in 401(k) plans or other tax-deferred investment plans. This brings us to a crucially important component of TIPS investing: "Only buy TIPS in a tax-deferred account," said Larry Swedroe, principal of Buckingham Asset Management.

Investors must pay taxes on the inflation adjustments of TIPS, while the adjustments themselves aren't paid out until maturity. If inflation shoots up as the economy recovers, investors could be footing a tax bill that actually exceeds the income paid out!

Looking for an inflation-hedged investment for a taxable account? A better option would be I Bonds, another inflation-adjusted Treasury security that individuals can purchase at www.treasurydirect.gov . With I Bonds, no taxes are due until maturity.

TIPS Risk: Volatility. TIPS Reward: Diversity

While TIPS are often touted as the safest investment in the world because of their hedge against inflation, they are far more volatile than, say, short-term Treasuries because they are pegged to inflation. Individuals who want less volatility from their fixed-income assets would be better investing in short-term fixed-income offerings or municipal bonds, Swedroe said.

Indeed, the quarterly returns on the Vanguard Inflation-Protected Securities fund highlights how topsy-turvy returns can be. However, the worst quarterly performance since its June 2000 inception was a 1.1% loss.

Important point: Vanguard TIPS fund skipper John Hollyer cautions that the fund's 16.61% return in 2002 was an anomaly caused by a combination of interest rates on conventional Treasuries falling as expectations for future inflation remained the same. Given the fund's current yield of around 1.5% and inflation expectations of 2.25%, a more realistic expectation for annual returns would be about 3.75%.

Also, you can lose money in a TIPS fund -- in fact, Hollyer cautions that it may happen as the yield on interest rates climb. "If real yields go up you could get some price declines, TIPS can perform pretty poorly," Hollyer said.

There's one last point to make about TIPS, which is the big benefit I impressed upon my anonymous friend: TIPS are just about the best diversification tool in the world. Why? Because they are a perfect hedge against inflation, TIPS actually have a negative correlation to stocks -- to employ a cliche, they zig when stocks zag. When inflation rises, TIPS offer higher nominal returns, whereas stock and bond prices are likely to fall.

"If you're getting into it because it's a hot asset class, it's the wrong reason," said Vanguard's Hollyer. "If you're getting into it because it's a good portfolio diversifier for the next 10 years, that's a great reason."

The Vanguard Inflation-Protected Securities fund shows returns can be volatile
Source: Vanguard

Indeed, in most quarters, a TIPS fund will lag behind stock funds. Although TIPS currently yield about half the 7% annual return stocks have averaged historically, they will outperform stocks about 25% of the time over 10-year periods, according to Jeremy Siegel, a Wharton professor and author of the outstanding Stocks for the Long Run.

"Government inflation-indexed bonds should be the asset of choice for investors who want to reduce their exposure to equities," Siegel advises in his book. Coming from one of the staunchest and most eloquent proponents of stock investing, that's no faint praise. If Dad -- rather, my friend -- doesn't heed my advice, he usually listens to Professor Siegel.

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