Nancy Davis’ hedging against rising prices, which was hailed when it was launched in 2019, has yet to hit the jackpot due to the crazy circumstances in the debt market.
Written by Brandon KochkodinForbes contributor
Since inception, IVOL’s total return is 8% lower than Schwab’s TIPS ETF
Tup again the mists of time to the distant land of 2019. Inflation was the stuff of legends, at least to anyone younger than Jay Powell – about as plausible as unicorns, fire-breathing dragons, or a killer virus that would shut down the world economy.
Not so for Nancy Davis, the CIO of Quadratic Capital Management. While others asked if there was inflation dead, Davis introduced her firm’s Interest Rate Volatility & Inflation Hedge ETF (IVOL). IVOL is a chimera, a lion with a goat’s head protruding from its back. Most of its assets are held in a bond ETF that any mom or pop can buy. The rest of the money goes into options betting, which is off-limits even to many professional money managers because of the nifty ways they offer investors to lose their shirts. However, it’s the options that make IVOL unique and, if inflation expectations rise sharply and fast enough, could result in a windfall.
Davis’ timing couldn’t have been more perfect. By 2021, concerns about inflation shifted from the fringes to the front lines. IVOL’s assets under management soared to over $3.5 billion, no small feat for a burgeoning fund in the cutthroat world of ETFs. But while Davis’ warnings proved almost psychic, IVOL didn’t grab the brass ring. At least not yet.
Since its debut, IVOL has returned just 3% despite inflation hitting 40-year highs over the past year. Since March 2021, when the CPI broke through the Federal Reserve’s 2% inflation target, the IVOL ETF has fallen 15%. In both periods, investing in Treasury Inflation-Protected Securities (TIPS), one of the easiest, cheapest and most well-known ways to protect against inflation, has outperformed IVOL by 8% and 12%, respectively.
Davis pointed this out in an interview with forbes that IVOL is intended to hedge inflation expectations and not the consumer price index. She also noted that IVOL has a friendlier tax structure than the Schwab ETF, meaning the yield gap is narrower than it first appears (mileage may vary, so check with your tax advisor to estimate the amount detect).
Also, IVOL isn’t exactly what you would call cheap. Its 1% annual fee makes it look like a Ferrari in a parking lot filled with Hyundais. This is despite the fact that under the hood of IVOL – 85% to be exact – are the same assets held in a Charles Schwab TIPS ETF. Schwab fee: 0.04% per year or 25 times less than IVOL.
Davis tells forbes that IVOL was “crazy cheap for what we do” and that one of their clients called it “the vanguard of convexity”. She also suggested that a comparison to actively managed mutual funds with similar goals would be more appropriate.
The Davis fund charges a premium in part because it was the first ETF to include over-the-counter interest rate derivatives. It might not mean much to those who don’t know, but IVOL has effectively opened up a harsh frontier that even some sophisticated family offices and foundations have previously been unable to penetrate. Additionally, Davis, a former Goldman Sachs prop trader, actively manages the options page of the book.
IVOL is ‘crazy cheap for what we do’
The simple explanation for how IVOL works is this: it buys TIPS to protect itself against inflation, and then throws in a few options to increase its returns if all goes well. Over short periods of time when the options are not exercised, the fund lags the TIPS ETF (no secret, IVOL says so in its prospectus). But if these options strike, a jackpot could be in the offing.
Although there is no guarantee, rising inflation expectations usually lead to a steepening of the yield curve (ie the cost of borrowing increases faster than short-term borrowing for longer periods of time). Investors expecting the Federal Reserve to start whining about rate hikes (and maybe even going through with them) want to stay, well, ahead of the curve. If those stars align, IVOL’s options gains could shoot its returns into the stratosphere and make Davis a hero.
Almost four years after the curtain went up, IVOL remains on the launch pad.
If IVOL is at an impasse, it is because interest rate movements, particularly the spread between the 10-year Treasury rate and the 2-year on which IVOL bets, are not cooperating.
IVOL’s options are making money as the 10-year yield outperforms the 2-year. History suggests that the gap should be larger than it is today. Instead, the spread narrowed.
Today the 2-year-old brings more than the 10-year-old. This is what is known as an inverse yield curve. Why that happened is up for debate, but what matters to IVOL is that the inversion neutralized its options bets and weighed on returns.
“I think there will come a time when this will work really well in certain circumstances,” said Bryan Armor, Morningstar’s director of passive strategy forbes. “It’s just a market timing difficulty. IVOL can go through years and years of underperformance before it finally works.”
Of course, all of this doesn’t rule out the possibility that IVOL’s options will eventually strike gold. And we could be living through the perfect lineup right now, according to Davis, who believes the fund is successfully positioned even if stagflation looms.
“If you buy the fund now, you get all of these options for free,” Davis said forbes. “Our investors know that we are exposed to the yield curve. Our investors gave me high fives.”
But whether that will be enough to offset what has already been done is worth considering for anyone planning to buy and hold IVOL rather than use it tactically.
“You add complexity with options, plus there’s the 1% fee on top of a four basis point TIPS ETF,” Morningstar’s Armor said forbes. “It’s a challenge to see good performance over the long term.”
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