Treasury inflation protected securities (TIPS) produced negative returns in the fourth quarter, concluding their worst year since they were introduced in 1997. Real (inflation-adjusted) and nominal Treasury bond yields increased in anticipation of, and in reaction to, a mid-December announcement from the Federal Reserve that it would begin tapering its asset purchases starting in January 2014. Headline inflation dropped on a month-over-month basis in both October and November, which also weighed on TIPS. Market expectations for inflation decreased throughout much of the period until the Fed's tapering announcement spurred some optimism that U.S. economic growth was gaining momentum.
The Inflation Protected Bond Fund returned −2.20% in the quarter compared with −2.00% for the Barclays U.S. TIPS Index and −1.61% for the Lipper Inflation Protected Bond Funds Average. For the 12 months ended December 31, 2013, the fund returned −8.77% versus −8.61% for the Barclays U.S. TIPS Index and −7.55% for the Lipper Inflation Protected Bond Funds Average. The fund's average annual total returns were −8.77%, 4.99%, and 4.35% for the 1-, 5-, and 10-year periods, respectively, as of December 31, 2013. The fund's expense ratio was 0.56% as of its fiscal year ended May 31, 2013.
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The fund invests mostly in TIPS (almost 91% of assets as of December 31, 2013) to protect against higher actual or expected inflation. We diversify the portfolio into other fixed income securities, such as investment-grade corporate bonds and mortgage-backed securities, to earn attractive income, especially when inflation is benign or the cost of inflation protection is expensive. As a means of further diversification, we may also allocate to inflation-indexed securities in non-U.S. markets that we feel offer more attractive real yields and inflation dynamics relative to their U.S. counterparts. During the quarter, our overweight to longer-term TIPS hurt the fund's relative performance. On the plus side, our positions in investment-grade corporate, asset-backed, agency mortgage-backed, and commercial mortgage-backed securities outperformed TIPS and helped our relative results.
We believe TIPS remain in a transition period, as the reduction of Fed asset purchases could lift shorter-term real interest rates back into positive territory and pressure longer-term real rates even higher. Even with intermediate- and long-term TIPS yields at low positive levels, valuations in the sector remain stretched by historical standards, and various factors, including modest wage growth, minimal corporate pricing power, and muted commodity prices, could remain headwinds to the near-term inflation contribution to performance. At the same time, investors' concerns about the Fed's $4 trillion balance sheet and the potential long-term effects of an extended period of low nominal interest rates remain valid and continue to argue in favor of having exposure to inflation protected securities. Our current preference for holding longer-maturity TIPS, which offer decent real yields after a reasonable adjustment in 2013, reflects such a view.