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One year ago, I wrote an article that discussed Treasury Inflation-Protected Securities (TIPS). TIPS are important because they provide the best protection against inflation among the universe of fixed-income securities.

TIPS, however, are not perfect. In fact, several prominent investment professionals have publicly addressed TIPS-related issues over the past year. In this article, I'll discuss some of these issues and relate them to the concerns of sensible long-term investors.

TIPS are fixed-income securities whose face values adjust to keep pace with the Consumer Price Index (CPI), a common inflation indicator. Investors earn a fixed rate of interest on the inflation-adjusted face values. The amount of inflation compensation TIPS investors receive, therefore, directly depends on the CPI.

It's difficult to measure such a broad economic phenomenon as inflation. The government's methods are not perfect. To calculate the CPI, the government monitors the prices of a basket of goods and makes certain adjustments, including "hedonic" adjustments and substitution adjustments.

The government may make a "hedonic" adjustment when, for example, the price of a digital camera increases because of higher quality and/or better features. In this case, the price of the camera may not have increased for the purpose of calculating the CPI.

The government also may make substitution adjustments when they assume that consumers will substitute one good for another based on the price of one of the goods. For example, if the price of butter rises, consumers may instead use margarine. The higher price of butter, therefore, would not necessarily increase the CPI because the government assumes consumers will substitute margarine for butter.

"Talk about a con job!" Bill Gross, PIMCO's chief investment officer, wrote when discussing these CPI adjustments in his October 2004 Investment Outlook letter.

Mr. Gross added: "[These CPI adjustments] disserve buyers and holders of TIPS, which adjust inadequately to a faulty and near fraudulently calculated CPI that could total billions of dollars per year for TIPS holders."

The government also calculates the "housing" component of the CPI nonsensically. Instead of measuring changes in house prices, the government measures changes to the rental income homeowners could receive for renting their homes (regardless of whether homeowners are actually renting their homes).

In addition to subjecting investors to a new sort of risk—I'll call it "CPI calculation risk"—TIPS also may not yield a competitive real rate. In other words, TIPS are not immune from becoming overvalued (or undervalued) just because they adjust for inflation.

Assume, for instance, that a 10-year TIPS note has a yield-to-maturity of two percent, and a 10-year traditional Treasury note has a yield-to-maturity of six percent. In this example, investors expect that inflation will be about four percent over the next ten years. If inflation is less than four percent, the traditional Treasury note would outperform the TIPS note because the TIPS note's overvalued purchase price would've reflected a higher inflation expectation.

Unfortunately, inflation predictions are purely speculative. The CPI only tells investors what inflation was, not what it will be; therefore, determining whether or not TIPS are overvalued or undervalued is more art than science. Consequently, long-term investors should consider TIPS as tools for neutralizing inflation rather than as speculative instruments.

Long-term investors will find that TIPS have an inherent advantage over traditional bonds when it comes to keeping up with inflation. An investor can hold a 20-year TIPS bond and reasonably expect that its return will, at least, equal inflation. An investor cannot safely assume that holding a traditional 20-year Treasury bond will return the inflation rate.

Preservation of purchasing power is the first goal of saving for retirement. Inflation erodes purchasing power. If inflation was, hypothetically, just three percent every year for the next twenty years, an investor's $250,000 retirement savings would be worth only $138,418.94 due to inflation.

TIPS automatically neutralize that inflation risk. Despite the difficulties associated with measuring inflation and, thus, adjusting TIPS's face values, they should still be a part of an investor's fixed-income portfolio.

Note: This article appeared in the March 23, 2005 edition of The Daily Record, a law and business newspaper published in Rochester, New York.

There are several risks universally associated with investments in fixed-income securities. Some of these risks include default risk, liquidity risk, reinvestment risk and interest rate risk. For United States Treasury securities; however, the market considers these fixed-income securities to be free of default risk. Investors, therefore, require that bonds issued by entities other than the federal government carry a premium yield-to-maturity so they can be compensated for the added default risk. This premium, called the credit spread, is the extra yield investors require for taking on the added default risk associated with investing in corporate bonds, and asset-backed and mortgage-backed agency bonds.

Credit spread risk, which is the risk that credit spreads will widen, is often overlooked by fixed-income investors. Today, corporate bond credit spreads are at or near their 13-year lows (see the accompanying charts).

Corporate bond spread history charts, by maturity: 2-year, 5-year, 10-year, 20-year, 30-year

As the Fed continues raising the Federal Funds rate to systematically slow an expanding economy and reduce the risk of future inflation, corporate bond investors may be harmed by both rising market interest rates and widening credit spreads.

Credit spreads, which are most often expressed for corporate bonds in basis points (one basis point is one-hundredth of a percent), widen during economic slowdowns because investors sell riskier corporate bonds and invest in safer Treasury bonds. This selling pressure decreases corporate bond prices and increases their yields. Investors take this "flight to quality" because they are concerned that corporations may not be able to meet their debt obligations as their cash flows decrease during periods of slower economic activity.

Today, the economy is expanding at a respectable rate with relatively low inflation. The equity and bond markets, however, indicate that future economic growth may slow. The shape of the yield curve, an excellent predictor of future economic activity, is still upward sloping, but it is much less steep than one year ago. This shape indicates an economy that will grow, but at a much slower rate.

Additionally, equity investors brought the Dow Jones Industrial Average down for the first three weeks of 2005. The Dow Jones had not begun a year with three straight down weeks since 1982. This poor performance indicates that equity investors do not have much hope for exceptional economic performance going forward.

If the market's tale is correct, we can expect the economy's growth to slow in the not-so-distant future. If and when this scenario occurs, credit spreads should widen. An investor can take care to protect his or her fixed-income portfolio from credit spread risk by reducing his or her portfolio's duration and increasing its average credit quality in response to this environment of historically narrow spreads.

Note: This article appeared in the February 2, 2005 edition of The Daily Record, a law and business newspaper published in Rochester, New York.

There are a few conflicting historical stock market phenomena pertinent to 2005, which is a post-election year and the fifth year of this decade. The S&P 500 index has performed remarkably well in the fifth year of decades since 1881. The index, however, has performed below average in years following an election, except when the incumbent President stays in power or when the post-election year is the fifth year of a decade.

The Fifth Year of Decades Phenomenon

In the fifth year of decades since 1881, the S&P 500 returned, on average, 27.7 percent, which more than doubles the average total return since 1881 of about 11 percent. In addition to the high return, the probability of a positive total return in the fifth year of decades since 1881 is a perfect 100 percent. The probability of a positive total return for all years since 1881 is about 72 percent.

Post-election Phenomena

Historically, the S&P 500 has performed below average in years following elections. In the last thirty post-election years, the S&P 500 has returned, on average, only about 8 percent, with a 43 percent probability of a negative return. When the post-election year is the fifth year of a decade, however (once every 20 years), the S&P 500 has performed well. In those six post-election years, the S&P 500 has, on average, returned about 24.6 percent, with zero negative return years.

The S&P 500 also performs above average in post-election years when the incumbent President stays in power. Since 1928, the S&P 500 index has averaged a total return of about 10.4 percent in post-election years, which is below the average for all years of about 12 percent. When the incumbent President stays in power, however, the post-election year returned an average of 13.7 percent compared to only 7.2 when the incumbent either loses the election or is ineligible to run for the Presidency again.

The positive outlook does not, however, mean investors should bet the farm, so to speak, on a positive equity market next year. After all, these phenomena may be entirely coincidental. They are interesting to consider, but stock market trends, like curses against the Boston Red Sox, can reverse themselves most unexpectedly. Consequently, careful, strategic diversification across all asset classes and internationally is still the wisest path to achieve superior long-term returns with the least volatility.

Note: This article appeared in the November 24, 2004 edition of The Daily Record, a law and business newspaper published in Rochester, New York.

There is an inherent conflict of interest when a person giving investment advice also works for a sell-side investment company (i.e. a brokerage) that manages mutual funds. Often, their advice will include their company's own mutual fund offerings regardless of the funds' merits (or lack thereof). This biased advice can diminish investors' portfolio returns.

Brokerages are in the business of selling investment products, services and securities like car dealerships are in the business of selling cars--their goal, despite what they say, is to sell cars at the highest price possible.

Many brokerages restrict access to mutual funds from competing brokerages and mutual fund companies. By limiting clients' choices, these brokerages can sell to their clients the highest-priced mutual funds, which are usually their affiliated funds rather than independent companies' funds.

These conflicted brokerages disserve their clients when their funds' expenses inappropriately impair one of the services they claim to provide: investment returns.

Observe, for example, total returns for the following S&P 500 index funds. Each of the following funds has the same simple objective (gross of fees and expenses): track as closely as possible the total return of the S&P 500 index by, generally, investing in the 500 large US companies in the index. (Bolded funds in the table are considered to be managed by non-conflicted investment companies.)

There's an obvious pattern to the data in the table: the funds with the highest expenses also had the lowest returns. Each of these funds, however, has the exact same objective, and yet there is as much as a 6.45 percent difference in holding period returns!

Some brokerages allow their clients to invest in competing funds, but only for a price. Competing funds must pay the brokerage to make their funds available to the brokerage's clients. Unfortunately for investors, these payments increase the expenses incurred by the competing mutual fund and, ultimately, diminish their returns. These competing funds, however, may still be a better alternative to brokerage firms' affiliated mutual funds.

Thankfully, this "pay to play" game is increasingly under the scrutiny of lawmakers. Recently, New York Attorney General Eliot Spitzer announced a probe into the dealings of insurance broker, Marsh & McLennan. It is alleged that Marsh accepted abnormally high bids in exchange for fees they called, "market service agreements." So instead of offering unbiased advice, Marsh allegedly steered their clients to the highest bidder in exchange for a kickback. This same sort of bad advice is still the status quo at full service brokerages with affiliated mutual funds.

Investors seeking investment advice and/or services should seek the counsel of investment companies whose interests are unbiased, aligned with shareholders' interests and independent of any conflicts. After all, bad advice, conflicts of interest and high fund expenses could cost thousands of dollars in investment portfolio returns.

Note: This article appeared in the October 27, 2004 edition of The Daily Record, a law and business newspaper published in Rochester, New York. Unfortunately, the newspaper put the wrong name on the article (they attributed the article to a co-worker with a similar last name) and they published the wrong title for the article. The newspaper published a correction notice in the October 28, 2004 edition

In the world of investments, historical data often help investment managers predict the future performance of the markets. My colleagues and I searched for periods with similar characteristics to today to help guide our investment decision-making during this period of almost inexplicably weak equity markets (although the high price of oil seems to have been taxing the markets recently). We found an eerily similar period with many significantly similar characteristics.

During the October 8, 1990 to October 8, 1992 and July 22, 2002 to July 22, 2004 periods we observed the following similarities:

1) First-term Republican presidents named Bush in an election year

1992: George H. W. Bush
2004: George W. Bush

2) Recently ended wars against Iraq

1991: The Gulf War officially ended on March 3, 1991
2003: Combat operations in the Iraq War officially ceased on May 1, 2003

3) The S&P 500 index's 50-day moving average breaks through the 200-day moving average on the upside

One of the classic technical signals of an impending uptrend is when the value of an index's 50-day moving average rises above the value of its 200-day moving average. A moving average is the average market value for a given preceding period (often 50 or 200 days).

In 1991, this event happened about three weeks before the official end of the Gulf War.

In 2003, this event happened two weeks after the official end of the Iraq War.

4) Modest uptrend in between accelerated upward movements

In 1991, the S&P 500 traded around its 50-day moving average for nine months. In the prior month, the index rose approximately 20 percent, and rose about 10 percent in the two weeks following the more modest uptrend.

In 2003, the index traded near its 50-day moving average for six months. In the prior two and a half months, the index rose 25 percent, and rose about 10 percent in the two months following the more modest uptrend.

5) The index tests, and bounces off, its 200-day moving average

The value of the S&P 500 bounced off the value of its 200-day moving average--after the events described in item four--twice in 1992 and once in 2004.

6) The index falls below its 200-day moving average

After testing its 200-day moving average, the index fell below its 200-day moving average in both 1992 and 2004.

7) The index's 50 and 200-day moving averages converge

One of the classic signals of an impending downtrend is when the 50-day moving average breaks through the 200-day moving average on the downside after a period of moving average convergence. In both 1992 and 2004, the 50 and 200-day moving averages started to converge in March (although they did not cross paths in 1992).

Conclusions

Of course, these similarities are interesting, but they mean little in and of themselves. One must also consider the performance of the index following the similar period. The index performed well for the remainder of 1992 and during 1993. In 1994, an unexpected rise in interest rates held the index in check for that year; however, the index subsequently experienced one of its best-performing periods from 1995 to March 24, 2000. In that period, the total return of the S&P 500 was 266 percent, which is an annualized total return of 28.1 percent--far above the long-term historical average of about 12 percent.

The phenomenal equity returns from 1995 to 2000 occurred during a period of less perceived risk than we experience today. The Cold War faded into distant memory, we quashed a rogue Iraqi dictator's invasion of Kuwait and terrorism was considered an unsubstantial threat, despite the bombing of the World Trade Center in 1993. Today's world, however, is perceived riskier, which could contribute to lower equity returns because equities perform poorly during periods of uncertainty.

With inflation restrained (so far), the economy growing at a respectable rate and interest rates still near all-time lows, and given the avoidance of a significant financial, geopolitical or geographic catastrophe, the historical evidence suggests that the equity markets will rise during the remainder of the year. At the end of this year, however, the outcome of the presidential election may have an impact on the performance of the markets.

Note: This article appeared in the August 4, 2004 edition of The Daily Record, a law and business newspaper published in Rochester, New York.

Inflation is a fixed-income portfolio's silent enemy. Someone who invests $10,000 in 10-year treasury bonds with a five percent coupon per year receives two payments of $250 per year throughout the maturity of the bond. Unfortunately, inflation can quietly erode the real value of those fixed interest payments.

What if there was a way to make fixed-income less fixed? Treasury inflation-protected securities (TIPS) do just that: they adjust an investor's principal to keep pace with the Consumer Price Index, a common inflation indicator, and investors earn interest on that inflation-adjusted principal.

Conceptually, TIPS yields should equal the real interest rate, which is the nominal interest rate minus the inflation rate, or, simply, a similar unprotected Treasury's yield minus the inflation rate. This relationship between Treasury and TIPS yields could help investors gauge the market's expectation of inflation.

Over the course of their seven-year existence, TIPS yielded, on average, 25 basis points per year more than they should have given the measured rate of inflation. The following table shows 10-year TIPS and Treasury yields, the implied inflation as determined by the spread in their yields, the measured inflation rate, and an error column that shows the difference between the implied and measured inflation rates.

Over the past two years, TIPS yields reflected a higher implied inflation rate than was measured. Investors inclined to use the spreads between Treasury and TIPS yields to predict future inflation would say that the market believes inflation will rise in the future. Historically, however, spreads between Treasury and TIPS yields were very inaccurate predictors of even just the direction of future inflation.

If an investor interprets the error column in the table above as a measure of the market's bias toward higher or lower future inflation, he or she would be led in the wrong direction in five of the TIPS' seven-year existence. The following table shows the predictions based on the error column, and whether each prediction was correct or incorrect in predicting the direction of the following year's inflation rate.

Of course, some may just write off this poor track record of using TIPS to predict future inflation to a number of factors, including the relatively undeveloped nature of the TIPS market. In the future, as the market for TIPS grows, perhaps it will become more useful for predicting inflation. In the meantime, however, they serve a valuable purpose in investor's portfolios.

In the long run, small favorable or unfavorable TIPS yields likely won't mean much to an investor's portfolio. TIPS will really earn their stripes in sustainable, highly troublesome periods of inflation like during the late 1970's and early 1980's. And with all economic signs pointing to higher inflation (e.g. economic expansion, astronomical commodity prices, the falling value of the dollar, etc.), TIPS should be at least a small part of your fixed-income portfolio.

Note: This article appeared in the March 24, 2004 edition of The Daily Record, a law and business newspaper published in Rochester, New York.