Nancy Davis’ hedge against rising prices, celebrated when it launched in 2019, has yet to hit the jackpot due to freakish circumstances in the debt market.
Written by Brandon Kochkodin, Forbes Staff
Since inception, IVOL’s total return is 8% lower than Schwab’s TIPS ETF
Travel back through the mists of time to the faraway land of 2019. Inflation, at least for anyone younger than Jay Powell, was the stuff of legend — 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 were asking whether inflation was dead, Davis was pitching her firm’s Interest Rate Volatility & Inflation Hedge 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 a bond ETF that any mom or pop can buy. The rest of the money goes to options bets that are off limits to even many professional asset managers because of the sophisticated ways they offer investors of losing their shirts. It’s the options, however, that make IVOL unique and what could, if inflation expectations rise sharply and quickly enough, provide a windfall.
Davis’ timing couldn’t have been more perfect. By 2021, fretting about inflation moved from the fringe to the frontline. IVOL’s assets under management soared to more than $3.5 billion, no small feat for an upstart fund in the cutthroat world of ETFs. But while Davis’ warnings proved almost clairvoyant, IVOL hasn’t grabbed the brass ring. At least, not yet.
Since its debut, IVOL has returned just 3% despite inflation hitting 40-year highs over the last year. Since March 2021, when the Consumer Price Index breached the Federal Reserve’s 2% inflation target, the IVOL ETF has slumped 15%. Over both timeframes, an investment in Treasury Inflation-Protected Securities (TIPS), one of the simplest, cheapest and best-known ways to guard against inflation, has outpaced IVOL by 8% and 12%, respectively.
Davis pointed out in a conversation with Forbes that IVOL is meant 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 gap in returns is narrower than it appears at first blush (mileage may vary, so consult your tax advisor to determine by how much).
What’s more, IVOL isn’t exactly what you’d call cheap. Its 1% annual fee makes it look like a Ferrari in a parking lot filled with Hyundais. That’s despite the fact that what’s under IVOL’s hood – 85% to be exact – are the same assets held in a Charles Schwab TIPS ETF. Schwab’s fee: 0.04% per year, or 25 times less than IVOL.
Davis told Forbes that IVOL was “crazy cheap for what we do” and that one of her clients called it “the Vanguard of convexity.” She also suggested a more apt comparison would be to actively managed mutual funds with similar objectives.
Davis’ fund asks a premium partly because it was the first ETF to incorporate over-the-counter interest rate derivatives. For those not in the know that might not mean much, but IVOL effectively opened up a rugged frontier that even some sophisticated family offices and endowments were previously unable to penetrate. Add to that the fact that Davis, a former Goldman Sachs prop trader, actively manages the options side 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 against inflation, then sprinkles some options on top to, if all goes well, goose its returns. Over short periods, when the options aren’t cashing in, the fund will lag the TIPS ETF (no secret here, IVOL says as much in its prospectus). But if and when those options hit, a jackpot could be in the making.
While there’s no guarantee, rising inflation expectations typically lead to a steeper yield curve (that’s to say that the cost of borrowing money for longer periods of time will rise faster than borrowing for the short term). Investors, expecting that the Federal Reserve will start yammering about rate hikes (and maybe, gasp, even go through with them) want to get ahead of the, well, curve. When those stars align, the gains on IVOL’s options could shoot its returns into the stratosphere and make Davis a hero.
Nearly four years after raising the curtains, IVOL remains on the launchpad.
If IVOL is in a rut, it’s because interest rate movements, specifically the spread between the 10-year Treasury rate and the 2-year that IVOL bets on, aren’t cooperating.
IVOL’s options make money as the yield on the 10-year outpaces that of the 2. History suggests the gap should be wider than it is today. Instead, the spread has narrowed.
Today, the 2-year yields more than the 10-year. It’s what’s called an inverted yield curve. Why that’s happened is up for debate, but what matters for IVOL is that the inversion has neutralized its options bets and been a drag on returns.
“I think there will come a time when this does really well in a specific circumstance,” Bryan Armour, Morningstar’s director of passive strategies, told Forbes. “It’s just a difficulty of market timing. IVOL can go through years and years of underperformance until it finally works.”
Of course, none of this rules out the possibility that IVOL’s options will eventually strike gold. And we might now be living through the perfect set-up, according to Davis, who believes the fund is positioned for success even if stagflation is what’s in store.
“If you buy the fund now, you get some of the options for free because the inversion is so huge and the fund is long options,” Davis told Forbes. “Our investors know we have exposure to the yield curve. Our investors have been high-fiving me.”
But whether that’ll be enough to offset what’s already been done is something worth considering for anyone that plans to buy and hold IVOL rather than use it tactically.
“You add complexities with options, plus there’s the 1% fee on top of a four basis points TIPS ETF,” Morningstar’s Armour told Forbes. “It’s challenging to see it performing well in the long term.”
Davis’ final quote was updated to reflect that only a portion of the options in the portfolio “are free.”
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