A year ago, on Oct. 28, 2012, I wrote a post titled ‘Vanguard’s new short-term TIPS funds: Better than cash?‘ and asked if funds investing in short-term Treasury Inflation-Protected Securities could be an alternative to a money-market fund.

Back then, short-term bond funds were the rage, and short-term TIPS funds were even more popular (which might have ended up skewing their returns.) I noted then that these funds are conservative:

• Since they hold only Treasurys, there is no credit risk.
• Since they hold only short-term maturities, there is lessened interest-rate risk.
• Their return will be bolstered if we see a period of unexpected inflation.

On the other hand, there are negatives:

• The return is miniscule.
• We have seen extremely low inflation.
• Although interest-rate risk is minimized, there is still a real risk that these funds will decline in value.

As an alternative, an investor could simply buy 5-year TIPS each year at auction  and hold them to maturity, building a ladder of 1- to 5-year TIPS and eliminating all risks. But that would eliminate liquidity, and that is a key part of the appeal of short-term TIPS funds.

But can they really substitute for a cash account? Here is how the Short-Term Inflation-Protected Securities ETF (VTIP) performed against cash (0.0% return) in the year since I wrote that article:

VTIP has lost 0.82% in value since Oct. 31, 2013, and according to Morningstar data, it has had a trailing 12-month total return (including dividends) of -0.88%. So it has not outperformed cash paying zero interest.

So, answering my question of a year ago: No, VTIP was not better than cash.

The fund showed unusual volatility in the summer of 2013 as the bond market grew worried about the potential end of Federal Reserve bond-buying. VTIP has since recovered, but you don’t expect to see this kind of volatility in a fund you are holding as a cash alternative.

Take a look at how VTIP has performed against another ETF, the Vanguard Short-Term Corporate Bond ETF (VCSH), a fund that would be considered slightly more risky than a short-term Treasury ETF:

While VTIP initially outperformed short-term corporates, the performance of the two funds ends up being nearly identical over the last year, with both losing about 0.8% of value in NAV.

However, VSCH with its better yield had a much better total return over the last 12 months: 1.44%.

This chart sums up the year for VTIP and other bond funds, adding in Vanguard Prime Money Market (VMMXX) and Vanguard Total Bond ETF (BND).

In conclusion:

• VTIP underperformed cash as its net-asset value fell through 2013.
• VTIP underperformed short-term corporates, because in a time over very low inflation it couldn’t match the yield of corporate bonds.
• VTIP outperformed the total bond market, which yields more but faces higher interest-rate risk.