Assets have been pouring into Treasury Inflation-Protected Securities. But a recent report by the world's biggest bond fund manager questions whether using passively managed exchange-traded funds to invest in TIPS is a wise idea.

The paper by analysts at Pacific Investment Management Co. describes characteristics of the asset class and explains, in detail, why investors using active management could have an advantage in certain situations under specific market conditions.

Considering that the home of Bill Gross has now entered the exchange-traded funds market with index-based products -- including the first of a family of TIPS funds -- the research has spurred a lot of debate.

The Wall Street Journal even jumped into the fray, spinning the study as a way for Pimco to attack Barclays Global Investors. Of course, BGI represents the dominant player in ETFs with its index-based iShares family. And, BGI is in the process of being acquired by BlackRock, which is considered Pimco's major rival.

Among other points, the article noted that even indexing giant Vanguard only has an active mutual fund for TIPS and no passive product.

Sorting through all of the hyperbole, let's take a look at the newest battleground for the ages-old active vs. passive debate -- TIPS.

Bonds & ETFs

In reviewing how investors can use fixed-income ETFs as efficiently as possible, it's important to note that bond issues do not have a central exchange to trade over like stocks shares employ. As a result, pricing is difficult as bonds sometimes trade infrequency.  Bond indexes often rely on specialist to mark-to-market bonds that rarely trade for index pricing.

As addressed by others, bond ETFs can sometimes trade at premiums or discounts to their net asset values. That isn’t always a bad situation, but it’s definitely something to be aware of as a bond ETF investor.

Source: National Stock Exchange

Investors have certainly made a lot of use of TIPS through traditional index mutual funds as well as the more recent introduction of ETFs into the sector. The most popular is the iShares Barclays TIPS Bond Fund (NYSEArca: TIP). Since its 2003 inception, the fund has attracted more than $14 billion in net assets, making it the seventh- largest ETF on the market. In July, TIP saw inflows of $600 million-plus; in the initial seven months of the year, the ETF had topped $5.5 billion in net cash flow. (See related column here.)

Inflation seems to be a major theme for ETF investors as the SPDR Gold ETF (NYSEArca: GLD) has had inflows year-to-date of more than $10 billion, making it the second- largest ETF in total assets.  Investors consider gold intrinsically linked to expected inflation, whereas TIPS are directly linked to the consumer price index.

Investing in TIPS

The iShares TIPS fund is clearly an important part of the ETF industry and investors should be informed and aware of potential structural problems in the asset class.

According to the recent Pimco report, there are predictable inefficiencies of the TIPS market that any active manager could exploit at a passive investor's expense.

Pimco does have a dominance and expertise in managing bond portfolios.  However, passive ETF investments are efficient and useful for many different reasons and allow quick access to different portions of the TIPS marketplace.

Source: Morningstar

The above chart compares the market prices of TIP and its index, the Barclays Capital U.S. Treasury Inflation Protected Securities Index.  The return difference is not technically tracking error but gives a visual of the closeness of returns between the index and ETF.

Generally, excess return will give an ETF investor an idea of how efficient the ETF’s managers are tracking the rule based index, which has challenges since most indexes do not account for any transaction costs but are purely tracking the prices and total return of underlying assets.

According to iShares, the annualized performance difference between TIP and its index is 0.16% from Dec. 4, 2003 through August 28, 2009.  The expense ratio for this fund is 0.20%.

The report suggests that costly inefficiencies may be hidden even within tracking error in the way bond indexes report prices.  According to the report, most indexes report end of day prices of the bonds which gives passive managers, who are judged by tracking error, the incentive to buy securities at the end of the day prices.

Pimco estimates this kind of inefficient execution could cost passive managers 10 basis points a year as prices rise near the end of the day and adjust back downward the next day when passive managers make purchases in a predictable fashion.

Since this inefficiency is also priced into the bond indexes, investors cannot easily track the cost this is to them.

The report suggests one solution for passive management is to purchase TIPS and have indexes measured on a “volume-weighted average trading price” as opposed to traditional end of day price transactions.

Missing the Point

Investing passively in most asset classes is not a submission that inefficiencies do not exist in that marketplace or that managers cannot exploit them but that things like cost and active management risks matter.

Pimco recently came to market with a passive bond ETF investing in 1-5 year TIPS, giving investors access to the shorter maturity TIPS bonds.  It is this diversity among passive investments which allows investors to get precise access to the duration and other characteristics they prefer while maintaining a cheap, diversified basket.

With the vast amount of ETF choices, the point of using passive ETFs in a portfolio is not only to get passive exposure to the asset class but the ability to invest with precision.  With the introduction of the Pimco 1-5 Year US TIPS Index Fund (NYSEArca: STPZ), the TIPS ETF marketplace is more diverse than even, giving investors the ability to build complete portfolios, finding a right duration or interest rate sensitivity and exposure to inflation both domestically and abroad.

This ability for investors to use static, passive ETFs to build complex and precise portfolios is what using ETFs to be an asset allocator is all about, giving the investor powerful tools to invest efficiently.  Having that kind of control over duration, maturity, and issuing country for under 20 bps is more important than small costs of inefficiencies that active managers may or may not take advantage of.

Also, as assets continue to flow into these funds, ETF management will develop more efficient ways to handle obvious problems.

In fact, Matt Tucker, head of U.S. fixed-income investment strategy at BGI, has discounted the Pimco report.

He points out that at the lower turnover rates of passive ETFs -- which leads to lower costs – investors actually gain a level of transparency that can translate into more flexibility when obvious problems in the marketplace exist or their circumstances change.