Nancy Davis’ hedge against rising prices, celebrated when it launched in 2019, has yet to hit the jackpot due to freak circumstances in the debt market.
Written by brandon kochkodinForbes Staff
IVOL total return 8% lower than Schwab TIPS ETF since inception
youtravel back through the mists of time to the faraway land of 2019. Inflation, at least to anyone younger than Jay Powell, was the stuff of legend, as plausible as unicorns, fire-breathing dragons, or a killer virus that would shut down the world’s economy.
Not so for Nancy Davis, the CIO of Quadratic Capital Management. While others asked if inflation was dead, Davis was launching his company’s Interest Rate Volatility Inflation Hedge ETF (IVOL). IVOL is a chimera, a lion with a goat’s head protruding from it. Most of his assets are held in a bond ETF that any mom or dad can buy. The rest of the money goes into option bets that are out of the reach of even many professional asset managers due to the sophisticated ways they offer investors to lose their shirts. However, it is the options that make IVOL unique and that could, if inflation expectations rise sharply and fast enough, provide a windfall.
Davis’ timing couldn’t have been more perfect. By 2021, inflation concerns have moved from the periphery to the front line. IVOL’s assets under management ballooned to more than $3.5 billion, no small feat for an upstart fund in the cutthroat world of ETFs. But while Davis’s warnings turned out to be almost clairvoyant, IVOL hasn’t gotten hold of 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 consumer price index exceeded the Federal Reserve’s 2% inflation target, the IVOL ETF has plunged 15%. In both timeframes, an investment in Treasury Inflation-Protected Securities (TIPS), one of the simplest, cheapest, and best-known ways to hedge against inflation, has outperformed IVOL by 8% and 12%, respectively.
Davis noted in a conversation with Forbes that IVOL is intended to cover inflation expectations and not the consumer price index. He also noted that IVOL has a more tax-friendly structure than the Schwab ETF, which means the gap in returns is narrower than it appears at first glance (mileage may vary, so consult your tax advisor to determine how much).
Also, IVOL isn’t exactly what you’d call cheap. Its 1% annual fee makes it look 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) are the same assets found in a Charles Schwab TIPS ETF. Schwab fee: 0.04% per year, or 25 times less than IVOL.
Davis said Forbes that IVOL was “very cheap for what we do” and that one of its clients called it “the Vanguard of convexity”. He also suggested that a more appropriate comparison would be with actively managed mutual funds with similar objectives.
Davis’s fund requests a premium in part because it was the first ETF to incorporate over-the-counter interest rate derivatives. For those unaware, it may not mean much, but IVOL effectively opened up a rugged frontier that even some sophisticated family offices and crews were previously unable to penetrate. Add to that the fact that Davis, a former Goldman Sachs accessories trader, actively manages the options side of the book.
IVOL is “very cheap for what we do”
The simple explanation of how IVOL works is this: you buy TIPS to hedge against inflation, then add some options to, if all goes well, increase your profits. In short periods, when the options are not cashing, the fund will lag the TIPS ETF (it’s no secret here, IVOL says so in its prospectus). But if and when those options arrive, a jackpot could be in the offing.
While there is no guarantee, rising inflation expectations generally lead to a steeper yield curve (i.e., the cost of borrowing money for longer periods of time will rise faster than the cost of borrowing short-term). . Investors, waiting for the Fed to start babbling about rate hikes (and maybe, gasp, even go through with them) want to get ahead of the curve. When those stars align, IVOL’s option gains could skyrocket his returns into the stratosphere and make Davis a hero.
Nearly four years after the curtain was raised, IVOL remains on the launch pad.
If IVOL is stuck, it is because interest rate movements, specifically the spread between the 10-year Treasury rate and the 2-year rate that IVOL is betting on, are not cooperating.
IVOL options make money as the yield on the 10-year bond outperforms the 2-year bond. History suggests that the gap should be larger than it is today. Instead, the spread has been reduced.
Today, the 2-year-old yields more than the 10-year-old. It is what is called an inverted yield curve. Why that happened is up for debate, but what matters to IVOL is that the investment has offset its option bets and been a drag on returns.
“I think there will come a time when this works really well in a specific circumstance,” said Bryan Armor, Morningstar’s director of passive strategies. Forbes. “It’s just a market timing difficulty. IVOL can go through years and years of underperformance until it finally works.”
Of course, none of this rules out the possibility that IVOL options will eventually strike gold. And we may be living in the perfect setup now, according to Davis, who believes the fund is positioned 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 that we have exposure to the yield curve. Our investors have been giving me a high five.”
But whether that will be enough to make up for what has already been done is something worth considering for anyone planning to buy and hold IVOL rather than use it tactically.
“It adds complexities 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 it work well in the long term.”
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