The US Treasury first implemented Inflation-Protected Bonds (TIPS) in 1997, and they now make up about 7% of the Treasury market.  Since then, inflation has rarely gone above 3% until 2021. Tariffs (customs duties) began surging in 2018, and President Trump is now implementing widespread tariffs. With retailers having low profit margins, these tariffs will mostly be passed on a tax on consumers. This article represents my research on how to invest the bond portion of a portfolio to reduce volatility and prepare for higher inflation.

Inflation Forecasts

Inflation by various measures has fallen below 2.3%. Tariff increases were announced on April 2^nd, and it takes time for products with the additional tariffs to reach the shelves. The Fed – Monetary Policy: Beige Book describes prices increasing at a moderate pace. The report says, “All District reports indicated that higher tariff rates were putting upward pressure on costs and prices.”

The Philadelphia Federal Reserve Second Quarter 2025 Survey of Professional Forecasters shows that economists estimate that inflation will peak at 3.4% next quarter and decline to 2.5% in 2026 and 2.1% in 2027. The Organisation for Economic Co-operation and Development released its OECD Economic Outlook, Volume 2025 Issue 1, with estimates that inflation in the US will average 3.2% in 2025 and 2.8% in 2026. In “2025 Economy Watch”, The Conference Board estimated that inflation would average 2.9% in 2025 and 3.0% in 2026. The International Monetary Fund database estimates that consumer prices in the US will be 3.0% in 2025, 2.5% in 2026, and 2.1% in 2027.

In spite of these noble efforts to estimate inflation, there is too much uncertainty in policy and too many unknowns regarding geopolitical risk and supply chain disruptions to have a reliable forecast. Following the escalation of the Israeli-Iran conflict in June, oil prices rose 22% from a low of $60 to $73 on June 15^th.  Geopolitical risks and supply chain disruptions have the potential to exacerbate tariff-induced inflation. I expect moderate rises in inflation in a slowing economy with the Federal Reserve lowering rates toward the end of the year.

Post-Pandemic Five-Year Return

During the past five years, the US has experienced the COVID pandemic, massive stimulus, ensuing inflation, and rapid monetary tightening. As shown in Figure #1, the yield curve has responded with the entire curve normalizing by June 2022. In 2023 and 2024, the short end of the curve rose and portions of the curve inverted as the Federal Reserve raised rates to fight inflation. Today, the short end of the curve is falling as the economy slows and investors anticipate lower rates, and the long end remains high, possibly impacted by the prospects of higher deficits.

Figure #1: Yield Curve June 2020 to June 2025

Source: Author Using St. Louis Federal Reserve FRED database

Now, as tariffs take effect amidst rising geopolitical risk, we can anticipate a resurgence of inflation to some extent. Let’s take a 30,000-foot-high level look at bond performance over the past five years. It should be no surprise that bonds with shorter durations have done the best because those with longer durations have been battered by rising long-term rates.

Table #1 contains most of the Lipper Bond Categories divided into “safer”, “moderate risk”, and “rate sensitive” Lipper Categories. Over the past five years, high yield funds with shorter durations and Flexible Income funds were the best performing, followed by Ultra-Short Bond, Absolute Return Bond, and Inflation Protected Bond, and Multi-Sector Funds. These are the same bond categories that have performed the best over the past three months. The Lipper Category of Inflation Protected Bonds is not segregated by duration which is the focus of the next section.

Table #1: Lipper Bond Category Performance – Five Years

Source: Author Using MFO Premium fund screener and Lipper global dataset.

Figure #2 shows the relationship between annualized percent return for the past five years and duration for inflation-protected bonds and absolute return bond funds.

Figure #2: Bond Performance Versus Effective Duration

Source: Author Using MFO Premium fund screener and Lipper global dataset.

I retired in 2022 and began using Financial Advisors at Fidelity and Vanguard about that time. They tend to rely on core and general bond funds, which over the long term have a low correlation to stocks. I manage the more conservative sub-portfolios of Traditional IRAs. To prepare for tariff-induced inflation, over the past nine months, I have increased allocations to ultra-short and short-term bond funds, absolute return bond funds, inflation-protected bond funds, and multi-sector funds.

The Great 2020 to 2025 Inflation Laboratory

The post-COVID pandemic time period provides an excellent opportunity to understand how inflation-protected bonds perform. The bottom half of the chart shows inflation as measured by the personal consumption expenditure index (year over year), the Federal funds rate, which is the Federal Reserve’s primary tool for slowing the economy to reduce inflation, and the 10-Year Treasury. The top half of the chart shows the cumulative returns of short-term government bonds (solid red line) and short-term Treasury inflation-protected bonds (dashed red line) compared to intermediate government bonds (solid black line) and intermediate-term Treasury inflation-protected bonds (dashed black line) performed.

Figure #3: Cumulative Bond Return vs Inflation and Yields

Source: Author Using St. Louis Federal Reserve FRED database and MFO Premium fund screener and Lipper global dataset.

Point A in the figure above is when the Federal Reserve began raising short-term rates (orange line). Point B is when inflation (blue line) began to fall and the rise in the 10-year Treasury rate (gray line) began to flatten. Point C is when the Federal Reserve stopped raising short-term rates.

The storyline is that intermediate inflation-protected bonds performed best prior to Point A, when inflation was rising, while intermediate government bonds began to perform poorly as intermediate rates began to climb. Up to point B, intermediate inflation-protected bonds began to perform poorly as inflation plateaued and intermediate rates continued to rise. Prior to Point C, both short- and intermediate-term inflation-protected bonds outperformed their nominal counterparts as inflation fell but remained above 2%, and rates stabilized. After Point C, short-term bonds, especially inflation-protected, outperformed as short-term rates fell and intermediate rates remain elevated. Short-term inflation-protected bonds continue to perform well in 2025.

Table #2: Bond Fund Performance By Year

Source: Author Using MFO Premium fund screener and Lipper global dataset.

Figure #4 shows all inflation-protected bonds (blue circle) and real return bonds (red triangle) by year overlain onto a chart of inflation (PCE YOY), Fed Funds rate, and 10-year Treasury rate. I favor the bonds with shorter durations at this time.

Figure #4: Bond Performance vs Effective Duration By Year

Source: Author Using St. Louis Federal Reserve FRED database and MFO Premium fund screener, and Lipper global dataset.

Imaginable Risks

What we saw in the previous section are inflation and interest rate risks. A recession was avoided. There are other risks that can impact performance. Slowing growth can lead to a recession or, worse yet, a recession with higher inflation is known as stagflation which presents problems for the Federal Reserve. Isolationism and trade wars can lead to supply chain disruptions, retaliatory tariffs, and even higher inflation. Economists that I follow agree that the budget proposal will lead to higher deficits and further increases in the national debt, which can lead to higher rates and slower growth. Equity valuations are high, which are tailwinds for domestic stocks.

For these reasons, I have taken precautions to reduce my stock-to-bond allocation from 65% to 50%, maintain bond ladders for around seven years, increase allocations to short-term bonds, and invest in funds to protect against inflation. I maintain a diversified global allocation to stocks and bonds.

Table #3 contains some of the high-performing funds that protect against inflation. They are sorted from the highest risk-adjusted return (Martin Ratio) on the left to the lowest on the right.

Table #3: Selected High-Performing Inflation-Protected Funds – Five Years

Source: Author Using MFO Premium fund screener and Lipper global dataset.

Figure #5: Selected High-Performing Inflation-Protected Funds – Five Years

Source: Author Using MFO Premium fund screener and Lipper global dataset.

Figure #6: Selected High Performing Inflation Protected Funds – YTD

Source: Author Using MFO Premium fund screener and Lipper global dataset.

My Strategy

Over the past several months, I have rotated from my worst-performing bond funds into inflation-protected bond funds and purchased the PIMCO Inflation Response Multi-Asset Fund (PZRMX) mentioned by David Snowball last month. I have bought mostly Vanguard Short-Term Inflation-Protected Securities Index (VTAPX, VTIP). I also bought Fidelity Inflation-Protected Bond Index Fund (FIPDX), which has a somewhat longer duration, and will monitor it for a possible sale if performance falls.

I became interested in adding Treasury Inflation-Protected Bonds to my bond ladders after reading, Retirement Planning Guidebook by Wade Pfau, among other books. He explains that TIPS outperform treasuries when inflation exceeds the implied break-even inflation rate. I created Figure #7 to show various breakeven inflation rates and inflation (PCE). I expect inflation to rise to close to 3.5% over the next year or two, while the breakeven rate is currently 2.3%.

Figure #7: Inflation Breakeven Rates and PCE Price Index (YOY)

Source: Author Using St. Louis Federal Reserve FRED database

As I wrote, in the Mutual Fund Observer March newsletter, ETF Bond Ladders, I am interested in using ETFs designed for bond ladders. Kim Clark describes Blackrock’s inflation-protected bond ETF with target maturities in These New TIPS ETFs Make It Easier To Build A Bond Ladder at Kiplinger. I bought iShares iBonds Oct 2030 Term Tips ETF (IBIG) to add to the 2030 rung on my bond ladder. The effective duration is 4.7 years, which gets shorter over time.

Closing

I now have approximately 7% of my bonds invested in inflation-protected bonds, including PIMCO Inflation Response Multi-Asset Fund (PZRMX). Another 40% is invested in bond funds with shorter durations. Next month, I will reevaluate inflation and geopolitical risk and make small adjustments if appropriate. I also have the 2025 rung in my bond ladder maturing in a few months, and need to determine where to reinvest the funds.

Matthews Asia is navigating a challenging period. Founded 30 years ago by Paul Matthews, the firm achieved a rare trifecta: consistently outstanding risk-sensitive returns across the entire fund family, outstanding success, such as the once $60 million AUM firm touched the $36 billion mark, and enormous professional respect as the country’s premier Asian investing specialist with a robust internal culture and deep bench.

The Matthews Asia of 2025 feels a long way from that success.

Assets have plummeted from $36 billion to $6 billion. Performance is mixed at best, with only three or four of 12 funds having above-average or higher risk-adjusted returns over the past 5- or 10-year periods. Something like half of the investment team has left the firm, some walking away and some pushed out. One of Morningstar’s most senior analysts, William Samuel Rocco, crystallized the concern:

The firm has suffered from extreme personnel turnover throughout the 2020s, and it has lost 15 members of its investment team during the past two years, including a former CIO/portfolio manager and other key individuals. The firm has hired Sean Taylor as a CIO/portfolio manager and added another portfolio manager in the past two years. There are now 18 individuals…on the investment team…But there were 31 individuals on the investment team in mid-2023 and 38 in 2020. Moreover, Cooper Abbott left the firm in April 2025, less than three years after joining the firm as CEO.

Matthews has replaced Abbott with Mark Headley, who had ample success [in several roles at Matthews before his retirement]. But Headley, Taylor, and their colleagues have daunting challenges to address. Most of the firm’s strategies have posted mixed, or worse, returns in recent years, and investors have pulled assets away.

We spoke with Mark Headley in June 2025. When asked about the suggestion that Matthews had lost its way, his response [I’m paraphrasing here] was: “Yep, pretty much.”

In an hour-long conversation, we pursued two questions with Mr. Headley: (1) what went wrong? and (2) is it fixable? The shortest [still paraphrased] version of his answers: (1) We screwed up our internal culture to the extent that it stopped producing good results and (2) I’m pretty sure we can. “There are still good bones there.” We’ll know within three years.

What happened to Matthews’ culture? There were two changes, complicated by a third factor.

Change one: they got too big and perhaps got a bit full of themselves. In the mid-2010s, everything worked: money was pouring in, performance was perking along, funds grew, the team grew, and salaries grew. But somewhere in there, identity was lost. By Mr. Headley’s estimation, a 40-person investment team is not “a team,” it is at best a bunch of talented, competitive people occupying the same space. They were a collection of teams, not a single team, and that made a huge difference. Collaboration reduced, cooperation fell, silos arose, and teams saw themselves in competition with one another for resources and attention. The whole became weaker than its individual parts.

Change two: leadership stopped leading. Building and sustaining cultures is hard. It takes a very distinctive set of skills to pull it off: a mindset that loves challenge and is willing to challenge others, a mindset that asks “where do we need to be in five years and what do I need to do this week to move us in that direction?” (If you ever wonder about the fundamental flaw in Karl Marx’s thinking, this is it. He never valued the intellectual work of “the capitalist class,” who organized, strategized, and supported “the working class.” He saw anyone collecting a paycheck but not working on the factory floor as dead weight. They are not.) Arguably the leadership became more laissez-faire, hiring talented people but not taking responsibility for their growth, not holding them responsible for their actions (for example, not calling out a triple-digit turnover ratio in a buy-and-hold portfolio) and not considering the entire range of skills required (including communication skills and the ability to get people excited about the strategy) in their personnel decisions. The retreat into silos meant that the teams, and the leadership, no longer took time to assess the macro-level forces shifting the entire world.

The influence of investment professionals waned as portfolio managers retreated into silos, and the influence of sales and marketing grew. That’s rarely a good thing since the understandable impulse of a sales team is to produce more of whatever is currently sellable.

The wild card factor: Xi Jinping upset all of the leadership’s earlier assumptions. The firm always counted on China, however flawed that now seems, to move steadily and relentlessly toward becoming a rational economic actor. Mr. Xi, instead, reasserted greater centralized control. Those developments weakened the case for “Asia” as a distinct asset class. Rather than a distinct global driver, investors began thinking of Asia as just one part of the emerging markets puzzle. Assets then shifted from Asia-centered funds to those with broader mandates.

Can Mr. Headley fix it? He thinks so. His simplest metric: if Matthews can reach around $12 billion AUM within three years, they’ve won.

Mr. Headley starts with a different perspective than most. He does not want to return to the glory days. He does not want 35 or 40 portfolio managers in the building. He does not want a steady stream of new “products”. He does not want $36 billion in assets. He does not believe that any of those are sustainable states for a mission-centered boutique manager.

More sustainable: $10-12 billion in assets, 20 or so investment professionals, a willingness to see Asia in its larger context, and perhaps fewer funds than they manage now. Also important is to bring stability back to its investment team, led by Sean Taylor, who has over 30 years of experience in emerging markets, or, where necessary, bring in some new talent.

His plan, so far as I understand it, is (1) to look at everything with fresh eyes and (2) to rebuild a winning culture. The “look at” part includes an assessment of what works, and what’s been limping along, what’s central and what’s merely a niche, and, most importantly, who they can build around. That is, who on the staff has the entrepreneurial mindset, passion, and communication abilities that will allow them to champion their own strategies and, eventually, to lead the firm.

The “rebuild” part comes down to teaching portfolio managers that failure is inevitable and not shameful; you shouldn’t hide it, you need to learn from it. In part, that requires owning up, talking through, and strategizing. All of which is some combination of alien and scary. Part of Mr. Headley’s job is to make it normal again. Part of the cultural rebuild is re-engaging with macro factors, allowing a top-down vision that complements bottom-up security selection. Without the top-down, a manager risks developing an obsession with picking up pennies in dark alleys. Finally, people need to be held accountable for their decisions.

Bottom line

I agree with Mr. Headley, “there remain good bones in there.” We came away from our interview with several strong impressions. First, Mr. Headley is very smart, very confident, and very competitive. Winning is in his DNA. Second, Mr. Headley did it before, helping guide a $60 million firm to become a $30 billion one. Third, he’s willing to ruffle feathers as the necessary price of improvement. He does not seem headstrong but does seem to have a clear sense of what success demands. He is betting that a vibrant internal culture and deep regional expertise – rather than index-hugging breadth – will win clients looking for long-term exposure to the world’s fastest-growing economies.

I would not bet against him.

Many and many a year ago, in the kingdom of ABC, Woody Allen was one of my very first guests. And we consented to take questions from an eager audience of mostly young people. Like ourselves.

The questioner looked like a high school girl and shouted to Woody from the balcony, “Do you think sex is dirty?”

Allen: “It is if you do it right.” (Dick Cavett, “As the comics say, These kids today! I tell ya.” New York Times, 9/13/2013)

I’d rather hoped that the observation originated with someone rather more wholesome, Groucho Marx or Mae West, for example, but we’re stuck with what the historical record gives us.

Three years ago, in the midst of a substantial market correction (equity portfolios were down 20%, 60/40 portfolios down 16% – in just six months), we wrote “Dirty sex, your spanked portfolio and planning for the next market” (07/2022). For reasons unclear to Midwesterners like me, we had a short-lived spike in our Google search ratings that month. Odd, since the point of the article was modest:

• First, we wanted to remind readers that corrections happen and are not a cause for portfolio upheaval
• Second, we wanted to commend high-quality small caps as a potential source of gain in the next market.

The question is, how good was the advice? We’ll look at it in turn.

Corrections do not warrant panic.

How might you respond, we asked, to the current bout of painful bruising?

1. If you have a well-designed strategic investment plan, do nothing.
2. If your portfolio is an unplanned collage of things best described as “it seemed like a good idea at the time,” build a plan before executing the plan.
3. If your portfolio is taxable, start identifying the cost basis of your shares.

From that date to this, “calm” was a profitable strategy. Here are the three-year returns from 10 Vanguard index funds representing major asset classes:

Source: Morningstar.com, 6/14/2025

The short version: an indolent investor with typical equity exposure, 60% seems the default, easily booked double-digit returns despite two crises (2022 and spring 2025) and, as a bonus, had time to read a good book or three (or to organize a pro-democracy protest, but that’s a separate tale).

Small and quality are worthy focuses

We wrote: “Reasonable commentators – from T Rowe Price and Leuthold to GMO and Warren Buffett – have argued that your greatest returns now might come from focusing on undervalued, high-quality companies that are growing dividends and are grounded in real assets. At a time when there are historic discounts for small vs large, value vs growth, and quality vs momentum, we asked the folks at Morningstar to look at which small-cap value funds had the highest quality portfolios.”

Small, quality, and value seemed to align with the recommendations of serious adults. Surprisingly, it also aligns with total returns over the past five years.

5-year performance by style box, as of 6/13/2025

Small-value won? Bet you didn’t see that coming! The past five years saw three major market dislocations (Covid, 2022’s inflation panic, and the spring 2025 tariff panic) and pretty uniformly double-digit returns. (The estimable Bill Bernstein, a self-described asset class junkie, once described small-growth as “a failed asset class” because they’re volatile, structurally overpriced and do not pay a risk premium for it.)

Morningstar ranked 160 portfolios from highest quality to lowest. Morningstar measures “quality” by assessing “the profitability and financial leverage of a company, based on an equally weighted mix of trailing 12-month return on equity and debt/capital ratios.” The table below includes the 11 funds considered small-cap value by Morningstar with the highest quality portfolios. (Why 11 and not 10? There was a tie.) This table is sorted by their 2022 portfolio quality, with Royce Special having the highest quality portfolio of the 160 Morningstar assessed, Auer second, and so on.

 Here’s how they have performed since then, relative to their category averages.

Quality small caps, three-year performance, sort by portfolio quality

Here’s how to read that table. The first three columns identify the fund: name, ticker, and Lipper category. The next two focus on total returns: annualized percentage and the amount by which they led or trailed their peers. The remaining columns offer simplified risk-return ratings. For each measure of risk versus return (Ulcer Index, downside deviation, bear market performance, MFO’s overall assessment, Sharpe ratio), MFO divides peer groups into five bands – best, above average, average, below average, worst – and color codes them. For your purposes, check for blue (best) and green (above average). Yellow is respectably average. Avoid red.

Conclusions:

1. Active worked. 75% of the active funds on the list outpaced their peer group and benchmark.

2. Passive didn’t, so much. Two of the three passive funds lagged their peers by, on average, 350 basis points, which is a big honkin’ deal when your total return is around 1%. The two funds that most dramatically trailed their peers were passive, smart beta EFTs. Pacer US Small Cap Cash Cows invests in small caps with exceedingly high free-cash flows. That led to vast overweights in tech and energy, and vast underweights in consumer goods and financial services. It’s a high turnover strategy (108%) with 200+ names in the portfolio. Acquirers Small and Micro Deep Value ETF tracks an index of 100 deeply undervalued small and micro-cap stocks. Their strategy is distinctive and not … umm, index-like:

   The initial universe of stocks is then valued holistically—assets, earnings, and cash flows are examined—in accordance with the Index methodology to understand the economic reality of each stock. Each stock is then ranked on the basis of such valuation. Potential components are further evaluated using statistical measures of fraud, earnings manipulation, and financial distress. Each potential component is then examined for a margin of safety in three ways: (a) a wide discount to a conservative valuation, (b) a strong, liquid balance sheet, and (c) a robust business capable of generating free cash flows. Finally, a forensic-accounting due diligence review is performed …

   As advertised, it invests in stocks much smaller and much more undervalued that almost any of its SCV peers. Like CALF, its annual portfolio turnover exceeds 100%. In the long term, the strategy tends to underperform its peers by 100-300 bps.

3. Aegis Value and James Small Cap worked best. Aegis, a purely outstanding and distinctive fund, beat its peers by 920 basis points, while James Small led by 640.

   Aegis Value Fund (AVALX) pursues long-term capital appreciation by investing in a concentrated portfolio of deeply undervalued, small-cap stocks—often in the lowest quintile of the market by price-to-book value. Managed by Scott Barbee since its 1998 inception, the fund targets overlooked out-of-favor companies, exploiting market inefficiencies and volatility where analyst coverage is sparse and liquidity is low. With a disciplined, research-intensive approach, AVALX has achieved amazing results. How amazing? Here’s Morningstar’s summary of its total returns – the top row – and what percentage it occupies among all small-value funds.

   

   Source: Morningstar.com, 6/14/2025

   Translation for the data-hesitant: the fund performed in the top 1% of all small cap funds for the past day, week, month, quarter, year and then 3-, 5, 10- and 15-year periods. We’ve profiled Aegis Value Fund in this month’s issue.

   The James Small Cap Fund (JASCX) seeks long-term capital appreciation by investing primarily in undervalued domestic and international small cap stocks. The target are companies with strong profitability and positive momentum, emphasizing quality “core” names with a slight value tilt. The fund typically holds a diversified portfolio (86 stocks as of March 2025), with about 28% of assets in its top 10 holdings, and maintains an amazing low turnover rate of 18%. Most small caps are far higher and Vanguard’s three small cap index funds have turnovers (13 – 21%) in this same range.

   The fund’s long-term performance, depending on the exact time frame, ranges from perfectly respectable to rock star.

   

   Source: Morningstar.com, 6/14/2025

   The fund’s three current managers have been 10 – 25 years of experience managing the fund. The team was once much larger (as much as nine managers in 2015-2018) but this tighter team seems to be working.

Bottom line

It’s the never-ending tale: planning works, patience works, calm works. Grabbing for bangles and baubles? Not so much.

The key question is: what’s the prospective that small and q1uality will continue to work in the years just ahead? Because of the incessant focus on one niche, the Favored Few within the large growth arena – the FANGs, then the MAG-7 and now All Things AI – and the continued growth of corporate earnings across the board, small and quality are both cheaper now than they were eight years ago. If you think that purchase price matters in future returns, that means they’re more attractive now than they were eight years ago.

The chart below also appears in the July 2025 Publisher’s Letter.

Source: Research Affiliates, 6/2025

The way to read that chart is to start by finding the little green diamonds. Those are the more-or-less current valuations of each strategy relative to its historic valuations. Green diamonds below the colored bar which illustrates the historic range from 10^th percentile to 90^th, signals that the strategy is now cheaper than it has been 90 or 95% of the time.

Finally, we’ve addressed the value of “calm” in an age of chaos in a series of articles by four different authors on The Chaos-Resistant Portfolio. (All are easy to find. Use the “Search MFO” box and enter just the word “chaos.”) The short version of those articles is that the price of calm in the years ahead is a thoughtful reevaluation of your portfolio allocation today.