Nancy Davis’ hedge against rising prices, which was lauded when it launched in 2019, has yet to hit the jackpot due to unusual conditions in the bond market.
written by Brandon CoccodinForbes Staff
Since inception, IVOL’s total return is 8% lower than Schwab’s TIPS ETF
T.go through Inflation, at least to anyone younger than Jay Powell, has been legendary, as plausible as unicorns, fire-breathing dragons, or a killer virus shutting down the global economy.
Not so Nancy Davis, CIO of Quadratic Capital Management. Others were asking if there was inflation, death, Davis was pitching her company’s Interest Rate Volatility & Inflation Hedging ETF (IVOL). IVOL is a chimera, a lion with a goat’s head sticking out of its back. Most of its assets are held in bond ETFs that anyone can buy. The rest of the money goes to option bets that are off-limits to even many professional money managers because they provide investors with a sophisticated way to lose their shirt. But what makes IVOL unique is its options, which can yield windfall gains if inflation expectations rise sharply and rapidly.
Davis’ timing couldn’t have been more perfect. By 2021, inflation concerns have moved from the fringes to the forefront. IVOL’s assets under management soared to over his $3.5 billion. This is no small feat for a start-up fund in the tough world of ETFs. But while Davis’ warning proved nearly clairvoyant, IVOL hasn’t grasped the brass hoop. At least not yet.
Since its debut, IVOL has returned just 3% last year, despite inflation hitting a 40-year high. The IVOL ETF is down his 15% since March 2021 when the Consumer Price Index surpassed the Federal Reserve’s 2% inflation target. In both timeframes, investments in Treasury Inflation Protection Securities (TIPS), one of the easiest, cheapest and best known ways to prevent inflation, outperformed IVOL by 8% and 12% respectively. increase.
In a conversation with Mr. Davis, Mr. forbes IVOL is meant to hedge inflation expectations, not the consumer price index. She also said that IVOL is more tax friendly than the Schwab ETF, meaning the return gap is smaller than it seems at first glance (mileage can fluctuate, so check with your tax advisor to see how much to determine).
Moreover, IVOL is by no means cheap. For a 1% annual fee, it looks like a Ferrari in a parking lot full of Hyundais. That’s despite the fact that what’s under the hood of IVOL (85% to be exact) is the same asset held in the Charles Schwab TIPS ETF. Schwab’s commission: 0.04% per annum, or 1/25th his IVOL.
davis customs forbes IVOL was “very cheap for what we do” and one of her clients called it “the Vanguard of Convexity”. She also suggested that a better comparison would be actively managed mutual funds with similar objectives.
Davis’ fund calls for a premium in part because it was the first ETF to include an OTC interest rate derivative. It may not mean much to the lesser known, but IVOL has effectively carved out a rugged frontier that was previously impenetrable to even some sophisticated family offices and endowments. It is. Add to that the fact that Davis, a former Goldman Sachs prop trader, actively manages the options side of the book.
IVOL is ‘very cheap for what we do’
Here’s a quick explanation of how IVOL works: Buy TIPS to protect against inflation and sprinkle some options on top of it. In the short period when options are not cashed, the fund will lag behind his TIPS ETF (no secret here, but IVOL’s prospectus says something similar). But if these options hit, they could hit the jackpot.
There are no guarantees, but rising inflation expectations usually lead to a steeper yield curve (i.e. long-term borrowing costs rise faster than short-term borrowing). Investors hope that the Federal Reserve will start booing about rate hikes (and maybe gasp and go with them), well, they want to get ahead of the curve. When these stars line up, IVOL’s option gains could return to the stratosphere and make Davis a hero.
Nearly four years after kicking off, IVOL remains on the launch pad.
If IVOL is in a rut, it’s because interest rate movements, especially spreads between 10-year Treasuries and the 2-year IVOL bets on, are uncoordinated.
IVOL options are profitable because the 10-year yield is higher than the 2-year yield. History suggests that the gap should be wider than it is today. Instead, spreads have narrowed.
Today, 2-year yields are higher than 10-year yields. This is the so-called inverted yield curve. Why that happened is a matter of debate, but what is important for IVOL is that the reversal neutralizes option bets and is a drag on returns.
“I think there will come a time when this really works in certain circumstances,” said Brian Armor, director of passive strategy at Morningstar. forbes“It’s just a difficult market timing. IVOL could be underperforming for years before it finally works.”
Of course, this doesn’t rule out the possibility that IVOL’s option will eventually make money. We may be experiencing the perfect setup now, according to Davis, who believes the fund is poised for success, even if stagflation lies ahead.
“If you buy the fund now, you get all these options for free,” Davis said. forbes“Our investors know we have exposure to the yield curve. Our investors gave me a high-five.”
But whether it’s enough to offset what’s already been done is something worth considering for anyone planning to buy and keep IVOL rather than use it tactically.
Morningstar’s Armor said, “Options add complexity and add a 1% fee to the 4-basis-point TIPS ETF.” forbes“It’s hard to see it working well in the long run.”