Nancy Davis’ hedge against rising prices, celebrated when it launched in 2019, has yet to hit the jackpot due to bizarre circumstances in the debt market.
Written by Brandon Kochkodinforbes team
Since inception, IVOL’s total return is 8% lower than Schwab’s TIPS ETF
Tunravel the mists of time to the distant land of 2019. Inflation, at least to someone younger than Jay Powell, was the stuff of legend—as plausible as unicorns, fire-breathing dragons, or a killer virus that would paralyze the world economy.
Not so for Nancy Davis, CIO of Quadratic Capital Management. While others asked whether inflation was dead, Davis was launching his company’s Interest Rate Volatility and Inflation Hedge (IVOL) ETF. IVOL is a chimera, a lion with a goat’s head protruding from its back. Most of their assets are held in a bond ETF that any mom or dad can buy. The rest of the money goes into betting on options that are off-limits even to many professional asset managers because of the sophisticated ways they offer investors to lose their shirts. It is the options, however, that make IVOL unique and what could, if inflation expectations rise sharply and quickly enough, deliver a windfall.
Davis’ timing couldn’t have been more perfect. In 2021, concern about inflation moved from the periphery to the front line. Assets under management at IVOL soared to more than $3.5 billion, no small feat for a fund new to the cutthroat world of ETFs. But while Davis’ warnings proved almost clairvoyant, IVOL didn’t grab the brass ring. At least, not yet.
Since its debut, IVOL has returned just 3%, despite inflation hitting a 40-year high last year. Since March 2021, when the Consumer Price Index surpassed the Federal Reserve’s 2% inflation target, the IVOL ETF is down 15%. Over both time frames, an investment in Inflation Protected Treasury Bonds (TIPS), one of the simplest, cheapest and most popular ways to hedge against inflation, outperformed the IVOL by 8% and 12%, respectively.
Davis pointed out in a conversation with forbes that IVOL aims to protect inflation expectations and not the Consumer Price Index. She also noted that the IVOL has a more tax-friendly structure than the Schwab ETF, meaning the difference in returns is less than it first appears (mileage may vary, so check with your tax advisor to determine 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 full of Hyundais. This is despite the fact that what is under the hood of IVOL – 85% to be exact – are the same assets held in a Charles Schwab TIPS ETF. Schwab rate: 0.04% per annum, or 25 times less than IVOL.
Davis said forbes that IVOL was “too cheap for what we do” and that one of its customers called it “the vanguard of convexity”. She also suggested that a more appropriate comparison would be actively managed mutual funds with similar objectives.
Davis’s fund asks for a premium in part because it was the first ETF to incorporate over-the-counter interest rate derivatives. For those who don’t know, this may not mean much, but IVOL effectively opened up a rugged frontier that even some sophisticated family offices and endowments were unable to penetrate. Add to this 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”
The simple explanation of how IVOL works is this: it buys TIPS to hedge against inflation, then spreads some options over the top to hopefully reap their returns. In short periods, when the options are not yielding, the fund will lag behind the TIPS ETF (no secret here, IVOL says so in its prospectus). But if and when those options pop up, a jackpot could be in the works.
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 will rise faster than that of short-term borrowing). Investors, waiting for the Federal Reserve to start moaning about rate hikes (and maybe, gasp, even stick with them) want to stay ahead of the, well, curve. When those stars align, IVOL options gains could skyrocket his returns into the stratosphere and make Davis a hero.
Nearly four years after opening the curtains, IVOL is still on the launchpad.
If IVOL is stuck, it’s because interest rate movements, specifically the spread between the 10-year Treasury rate and the 2-year Treasury rate that IVOL bets on, are not cooperating.
IVOL options make money because the 10-year yield exceeds the 2-year yield. History suggests that the gap should be greater than it is today. Instead, the spread has narrowed.
Today, the 2-year-old yields more than the 10-year-old. This is what we call an inverted yield curve. Why this happened is up for debate, but what matters to IVOL is that the reversal neutralized its options bets and was a drag on returns.
“I think there will come a time when this will work really well in a specific circumstance,” said Bryan Armor, director of passive strategies at Morningstar. forbes. “It’s just a market timing difficulty. IVOL can go through years and years of underperforming before it finally works.”
Of course, none of this rules out the possibility that IVOL options will eventually strike gold. And now we may be living in the perfect scenario, according to Davis, who believes the fund is poised for success, even if stagflation is what’s to come.
“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 are greeting me.
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 using it tactically.
“You add complexities with options beyond the 1% fee on a four basis point TIPS ETF,” said Morningstar’s Armour. forbes. “It is a challenge to see long-term performance.”
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