Bogleheads

[Cb]

A number of weeks ago like many of you I was copying & pasting TrevH's data on a variety of asset class returns from 1972 thru 2006. I then began to search for information on TIPS behavior. Time and again this Kothari paper was mentioned (most recently by Larry Swedroe on a DH thread) as having done a credible job of constructing a simulated TIPS dataset starting in 1953:

http://gnobility.com/ER/Shanke....h_TIPS.pdf

I emailed Dr. Kothari at MIT and asked him the following:

Dr. Kothari,

I'm, a recently-retired individual investor trying to improve my knowledge of investing. As my wife and I roll-out our 401K's to Vanguard we're going to a more broadly diversified portfolio using MPT concepts.

We now have access to a low cost cost TIPS fund at Vanguard and I'm giving seriously thought to diversifying our bond portfolio with TIPS. As I look for historical data on inflation-protected securities your name pops up frequently, most often mentioning a 2004 paper you had published in the Financial Analysts Journal in the Jan-Feb 2004 issue, "Asset Allocation With Inflation-Protected Bonds".

I have two questions regarding that article:

- given that over three years have past since you assembled that projections used in the article, and we now have ten years of actual TIPS data to consider, would you advise that I use the data depicted in the graph on page 7 (Figure 1, Overlapping Annual Returns Series....A. Nominal Returns) for my analysis of various multi-asset class portfolios?

- if so, would you mind sending the dataset in a text file or Excel format? (otherwise my plan is to fit gridlines to the graph and try to pick off year-end numbers by eye)

Thanks,


..his reply:

Dear Mr. Xxxx,

yes, you may use the data from the graph, and also you will have to make do with picking-off year-end numbers by eye. The analysis was done by a research assistant and the data are not readily available. Since you are focusing on year-end numbers, reading them off the chart is not a bad idea.

Best wishes,

SP

So here is what I did with the Kothari paper:

I zoomed then copied the nominal returns chart from the PDF,

Pasted it into PaintShop Pro, leveled it slightly, erased the Zero Bonds data, punched up the contrast & darkened the synthetic TIPS lines, then saved as a jpeg.

I then pulled the jpeg into Powerpoint, fitted dashed lines for Years & Returns, then eye-balled the intersections of the Kothari data at year-end for 1954-2001

http://gnobility.com/ER/Kothari_chart_data-rip.ppt

Here's the resultant list of data in Excel:

http://gnobility.com/ER/Kothar....S_data.xls

My inclination is to use the 1972 thru 2001 "simulated" data, and the actual TIPS returns for 2002-2006, because I think the simulated returns might be the better representation, as the earliest TIPS pricing as they were being introduced is probably a poor indicator of their future behavior.

Thoughts/comments?

Cb

[Barry Barnitz]

[CyberBob]

The first thing I did was slap down 5-year treasury returns right next to your synthetic TIPS returns. Here's what I found:

[BrianTH]

CyberBob,

That certainly looks like a pretty healthy "insurance premium" (as we have been calling the difference in long term expected return between TIPS and comparable nominal treasuries). And should the maturity on your comparable treasuries be higher? I don't know--I'm just asking.

[CyberBob]

[BrianTH]

Wait, longer bonds had a LOWER return? That doesn't make much sense (I don't think we have had 50 years of an inverted yield curve).

[Cb]

[Random Musings]

Since they are synthetic returns in the study - I assume the study does not take into account the possibilities that investors can "pick" when they want to purchase TIPS (ala Swedroe):

- only purchase TIPS when the fixed income component is high (for example 2.3%, and higher).

- as the fixed TIPS component goes higher - choose longer duration to "lock" in.

I would believe this would reduce the insurance premium.

Let alone, if you follow Larry S. advice and sell TIPS incrementally as the fixed component goes lower (and go into treasuries) - will that also further reduce the net insurance premium or eliminate it altogether?

RM

[CyberBob]

[BrianTH]

Random Musings,

Of course, you would have to compare all that to what would happen if you were using similar strategies with your nominal bonds.

CyberBob,

I guess that makes sense, but for me it least it was unexpected.

[CyberBob]

Hmmm...that's interesting.

When I view the table I made above with Firefox, the columns are neatly lined up. When I view it with Internet Explorer, they look all jumbled. Microsoft is evil!

[SmallHi]

Well, as has been mentioned before, TIPS don't appear that appealing over an entire interest rate cycle.

First, looking at the 1964-2006 period (the longest I have for all bond categories) we see the following returns:

1 month t-bills = +5.8%
6 month t-bills = +6.6%
1 year t-notes = +6.7%
2 year t-notes = +7.4%
5 year t-notes = +7.3%
20 year t-bonds = +7.4%
Inflation bonds = +7.0%

(there is an interest rate term premium, but you only need to go out 2-5 years to capture it, and the biggest rewards come from increasing maturities from just 1 month to 6 months. After that, benefits decline dramatically and flatten out beyond 2 years)

Also, listed below is the annual correlation with inflation:

1 month t-bills = .65
6 month t-bills = .55
1 year t-notes = .40
2 year t-notes = .38
5 year t-notes = (.12)
20 year t-bonds = (.29)
Inflation bonds = .05

Finally, since 1973 (starting date of good global equity data), I have listed the correlations of various fixed income securities with STOCKS:

1 month t-bills = (.07)
6 month t-bills = (.05)
1 year t-notes = (.06)
2 year t-notes = .01
5 year t-notes = .07
20 year t-bonds = .13
Inflation bonds = .33

Based on simulated 65% STOCK/35% BOND portfolios rebalanced annually, I could not find any fixed income security that was not preferable to TIPS based on sharpe ratios.

SmallHI

[yobria]

[Robert T]

cb,

Thanks for the paper and your effort to reproduce the 'synthetic' index.

The characteristics of the series in comparison to 5yr T-Notes seems to vary by time period. For example from 1975 to 2005 (adding Vanguard TIPS returns from 2002-05), the annualized return and standard deviation were 8.33 and 6.93 for 5yr T-Notes and 8.68 and 6.45 for 'synthetic' TIPS i.e. the 'sythestic' TIPS had higher return with lower standard deviation of returns over this period. Adding 50:50 5 yr T-Notes:TIPS to a global small and value tilted portfolio over this period both marginally increased returns and the standard deviation of returns over a portfolio with just 5-yr T-Notes as fixed income.

First post on this new forum - still trying out some of its functions.

Robert

[BrianTH]

Robert,

That makes sense to me because the mid-late 1970s were probably the best time by far for TIPS relative to nominal bonds.

[SmallHi]

Lets assume our base portfolio is 65% global stocks and 35% 5 Year Treasuries. Since 1973, our return/risk profile = 12.8%/11.8

If we substitute TIPS for 5 Year T-Notes, we maintain returns and increase risk: 12.8%/12.4

If we split our allocation evenly between T-Notes and TIPS, we simply split the risk difference: 12.8%/12.0

Finally, if we choose to get our inflation protection from shorter term nominal bonds (2 Year T-Notes), we reduce our portfolio risk slightly: 12.8%/11.6

Now, these are all very long term simulations and probably span one's investing lifetime. My opinion is that it doesn't really matter much. If you are the type that tends to get a bit squirely if your bond portfolio lags the overall bond market by a noticeable amount, then probably better off extending maturities a bit (as 2 Year bonds have had a rough go of it the last 10 - 15 years). If you are primarily concerned with portfolio volatility or have a large % of your portfolio in bonds, you may want to keep it short and sidestep the modestly more volatile longer term T-Notes and TIPS.

Tools for the task? ST Corporate should work for shorter maturities, Int'd Treasury for 5 Year Treasuries, and of course TIPS fund for TIPS.

SmallHI

[WorldBeta]

cb - the links are broken, do you have updated ones? thanks

[dumbmoney]

[Cb]

[WorldBeta]

i bet they have it in their Encorr software. . .here is a paper from them:

TIPS as an Asset Class
Peng Chen
Ibbotson Associates
225 N. Michigan Ave., Suite 700
Chicago, IL 60601
(312) 616 -1620

[grabiner]

[stratton]

[OptionAl]

TIPS are fine but for maybe 25% of fixed income. I really don't get it: Why invest in a product that is more volatile and probably going to be outperformed by a similar product and is subject to the whims of the government's inflation computations. I know - diversification and correlations. But when we're told we should invest 50% of fixed income in TIPS, to me it's like hearing we should invest half of our income in insurance.
I like 50%+ IT treasuries/CDs/munis/other, 25% ST (max), 25% TIPS (max). Probably as much real inflation protection as TIPS and some return as well.

[adalfu]

the links in the original post do not work... does anyone have access to these files?

thanks a plenty.

[Cb]