This Investment Fund, once .5 billion, was designed to Fight Inflation.  How Could He Lose The Battle?

This Investment Fund, once $3.5 billion, was designed to Fight Inflation. How Could He Lose The Battle?

Nancy Davis’ hedging against rising prices, celebrated when it launched in 2019, has yet to hit the jackpot due to rare circumstances in the debt market.

Written by Brandon KochkodinThe Forbes team

COMING behind

Since inception, IVOL’s total return has been 8% lower than Schwab’s TIPS ETF

Travel back through mists of time to the distant land of 2019. Inflation, at least to anyone younger than Jay Powell, was the stuff of legend — about as plausible as unicorns, fire-breathing dragons or a deadly virus that would end world economy.

Not so for Nancy Davis, CIO of Quadratic Capital Management. While others were asking if there was inflation 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 protruding from its back. Most of their assets are held in a bond ETF that 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 to lose their shirts. The options, however, are what make IVOL unique and what, if inflation expectations rise sharply and quickly enough, could provide a headwind.

Davis’ timing could not have been more perfect. By 2021, inflation concerns were moving from the fringes to the front line. IVOL’s assets under management grew to more than $3.5 billion, which is not insignificant for a start-up fund in the cut-throat world of ETFs. But while Davis’s warnings were all but obvious, IVOL didn’t grab the brass ring. At least not yet.

Since its inception, IVOL has returned just 3% despite inflation hitting 40-year highs in the past year. Since March 2021, when the Consumer Price Index exceeded the Federal Reserve’s 2% inflation target, the IVOL ETF has fallen 15%. Over both time frames, investing 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 revealed in a conversation with Forbes that IVOL is intended to hedge inflation expectations and not the Consumer Price Guide. She also noted that IVOL has a more tax-friendly structure than the Schwab ETF, meaning the gap in returns is narrower than it first appears (mileage may vary, so consult with your tax advisor to determine how much).

Plus, 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 under the hood of IVOL – 85% to be exact – are the same assets held by the Charles Schwab TIPS ETF. Schwab Fee: 0.04% per year, or 25 times less than IVOL.

Davis said Forbes that IVOL was “crazy free of what we do” and that one of its clients called it “Vardage of convexity”. She also suggested that a more appropriate comparison would be with actively managed mutual funds with similar objectives.

Davis’ fund commands a premium in part because it was the first ETF to incorporate over-the-counter interest rate derivatives. To the uninitiated that might not mean much, but IVOL effectively opened a rough frontier that even some sophisticated family offices and endowments could not penetrate before. Add to that that Davis, a former Goldman Sachs prop trader, actively manages the options side of the book.

IVOL is “crazy about what we do”

Nancy Davis

The simple explanation of how IVOL works is this: it buys TIPS to protect against inflation, then sprinkles some options on top, if all goes well, the goose returns. Over short periods, when the options are not trading, the fund will trail the TIPS ETF (no secret here, IVOL says as much in its prospectus). But if and when those options come in, a jackpot could be in the making.

Although there is no guarantee, rising inflationary expectations tend to result in a steeper yield curve (that is, the cost of borrowing money will rise for longer periods of time than borrowing get in the short term). Investors, expecting that the Federal Reserve will start yammering about rate increases (and maybe, gasp, even go through with them) are trying to get ahead of the, well, curve. When those stars align, the gains on IVOL options could shoot his returns into the stratosphere and make Davis a hero.

Almost four years after the curtains went up, IVOL remains on the launch pad.

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 IVOL is pegged on, are not cooperating.

IVOL options make money because the yield on the 10 year is higher than the 2. History suggests that the gap should be wider than it is today. Instead, the spread is narrowed.

Today, the 2-year yield is greater than the 10-year. It is called an inverted yield curve. Why that happened is debatable, but the important thing for IVOL is that the inversion has neutralized its options bets and has been a drag on returns.

“I think there will come a time when this will do very well in certain circumstances,” said Bryan Armour, Morningstar’s director of passive strategies. Forbes. “It’s just a difficulty with the timing of the market. IVOL can go through years and years of underperformance until it finally works.”

Of course, none of this leaves out the possibility that IVOL options will eventually strike gold. And we may be living through the perfect arrangement now, according to Davis, who believes that the fund is capable of achieving success even if we are destined for stagnation.

“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 put a lot of pressure on me.”

But whether that’s enough to offset what’s already been done is worth considering for anyone planning to buy and hold IVOL rather than using it tactically.

“You add complexities to options, and the 1% fee is on top of four basis points for the TIPS ETF,” Morningstar’s Armor said Forbes. “It’s challenging to see it performing well in the long term.”


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