The Fear Fund: Nancy Davis’ ETF Aims To Protect Investors From Scary Stuff, Like Recession And Inflation

Stocks have recovered from last fall’s crash, low interest rates stretch out to the horizon and the VIX volatility index is half what it was at Christmas. Sit back and coast to a comfortable retirement.

No, don’t, says Nancy Davis. This veteran derivatives trader runs Quadratic Capital Management, where her somewhat contrarian view is that investors, all too complacent, are in particular need of insurance against financial trouble.

The Quadratic Interest Rate Volatility & Inflation Hedge ETF, ticker IVOL, is designed to provide shelter from both inflation and recession. Its actively managed portfolio mixes inflation-protected Treasury bonds with bets, in the form of call options, on the steepness of the yield curve.

Those options are cheap, for two reasons. One is that, at the moment, there is no steepness: Yields on ten-year bonds are scarcely higher than yields on two-year bonds. The other is that the bond market is strangely quiet. Low volatility makes for low option prices.


“Volatility has been squashed by central bank money printing,” Davis says, before delving deep into the thicket of option mathematics. If volatility in interest rates rebounds to a normal level, her calls will become more valuable. Alternatively, she would get a payoff if the yield curve tilts upward, which it has a habit of doing when inflation surges, stocks crash or real estate is weak.

If IVOL is all about peace of mind for the investor, it’s all about risk for its inventor. Davis, 43, has poured her heart, soul and net worth into Quadratic, of which she is the founder and 60% owner. If the three-month-old exchange-traded fund takes off, she could become wealthy. If it doesn’t, Quadratic will struggle.

The fund showed its worth in the first week of August, climbing 2% as the stock market sank 3%. But it needs a much bigger shock to stock or bond prices in order to get big. It has gathered only $58 million so far. A crash had better arrive soon; IVOL’s call options expire next summer. Quadratic, moreover, needs to somehow scale up without inspiring knockoff products from ETF giants like BlackRock.

Davis was a precocious trader. As an undergraduate at George Washington University, she took grad courses in financial markets while earning money doing economic research for a consulting firm. She put some of her paychecks into a brokerage account. “Some women love to buy shoes,” she says. “I love to buy options.”

This was in the 1990s, a good time to indulge a taste for calls. Davis made out-of-the-money bets on technology stocks, which paid off well enough to cover the down payment, in 1999, on a New York City apartment. Nice timing.

There may be a sour grape, but there’s also truth in her current philosophy that hedge funds are not such a great deal for investors. ETFs, she says, are more liquid, more transparent and cheaper.

Davis spent a decade at Goldman Sachs, most of it on the firm’s proprietary trading desk, then did a stint at a hedge fund. At 31 she quit to actively manage two kids. Returning to Wall Street after a three-year hiatus, she worked for AllianceBernstein and then did what few women do, especially women with children: She started a hedge fund.

Quadratic, whose assets once topped $400 million, used a hedge fund platform at Cowen & Co. When Cowen ended the partnership last year, Davis set about reinventing her firm. There may be a sour grape, but there’s also truth in her current philosophy that hedge funds are not such a great deal for investors. ETFs, she says, are more liquid, more transparent and cheaper.

IVOL’s 1% annual fee is stiff, but Davis says it’s justified for a fund that is not only actively managed but also invested in things that ordinary folk cannot buy. If you want to duplicate her position in the Constant Maturity Swap 2-10 call due July 17, you’d need to know what banker to ring for a quote, because this beast is not traded on any exchange. Each of these calls, recently worth $7.71, gives the holder the right to collect a dollar for every 0.01% beyond 0.37% in the spread between ten-year interest rates and two-year interest rates. The spread has to move a long way up before the option is even in the money. But at various times in the past the spread has hit 2%. Could it do that again? Maybe, at which point the option pays $163.

Starting a firm like Quadratic is like buying an out-of-the-money call: long odds, big payoff. Davis is doing what she was doing in college. You can’t stop a trader from trading.

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Source: The Fear Fund: Nancy Davis’ ETF Aims To Protect Investors From Scary Stuff, Like Recession And Inflation

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Nancy Davis, founder and CIO of Quadratic Capital Management, introduces her new ETF that takes advantage of interest volatility and inflation expectations: IVOL. In this interview with Real Vision’s co-founder & CEO Raoul Pal, Davis deconstructs the structure of the ETF, highlights the cost of carry associated with the strategy, and discusses her macro outlook and where she thinks the yield curve is headed next. Filmed on May 29, 2019. Watch more Real Vision™ videos: Subscribe to Real Vision™ on YouTube: Watch more by starting your 14-day free trial here: About Trade Ideas: Top traders unveil their specific plans for cashing in on the market’s next move. In these short videos, our traders cut straight to the point and lay out their thoughts on the best risk-reward trades of the moment. Each episode concludes with a visual recap of trade details including profit-loss potential and trade duration. About Real Vision™: Real Vision™ is the destination for the world’s most successful investors to share their thoughts about what’s happening in today’s markets. Think: TED Talks for Finance. On Real Vision™ you get exclusive access to watch the most successful investors, hedge fund managers and traders who share their frank and in-depth investment insights with no agenda, hype or bias. Make smart investment decisions and grow your portfolio with original content brought to you by the biggest names in finance, who get to say what they really think on Real Vision™. Connect with Real Vision™ Online: Twitter: Instagram: Facebook: Linkedin: The ETF Play on Interest Rate Volatility (w/ Nancy Davis)… Transcript: For the full transcript visit: NANCY DAVIS: So we invest with options with a directional bias on everything. So our new product that we recently launched, IVOL, is the first inflation expectations and interest rate volatility fund out there. It’s a exchange traded product. RAOUL PAL: Does anybody even know what that means? NANCY DAVIS: So what we do is for an investor, if you’re an equity investor, you want to have tail protection, for instance. It’s hard to own equity volatility as an asset allocation trade because it decays so aggressively. So it’s a more benign way to carry volatility as an asset class from the long side using fixed income vol. It’s not as sensitive as equity vol, but it’s a lot lower level. Like, the vol we’re buying is 2, 2 basis points a day in normal space. So it’s very, very cheap, in my opinion, and it gives you a way to have an asset allocation to the factor risk of volatility without having as much decay as you would in the equity space. And then for a fixed income investor, the big risk there is obviously Central Bank policy, fiscal spending, trade wars, as well as inflation expectations. And we saw a need to really give a fixed income investor a way to capitalize on the deflation that’s been priced into the market for the next decade. I mean, so current US inflation is around 2%. The five-year break-even is 1.59%. So that’s an opportunity in an option space. And so it’s long options with TIPS. And so that gives investors exposure. It gives you inflation-protected income, but also options that are sensitive to inflation expectations. And we think it’s pretty– you know, you’re never going to time these macro calls perfectly. But given the Central Bank in the US is so focused right now on increasing inflation expectations, and there’s been so much talk about the yield curve inverting– and that’s kind of crazy. If you step back and you’re like, all right, we have a $3.9 trillion balance sheet. We have a fiscal budget deficit. We have unclear or radically changing monetary policy. If you look where we are now with so many cuts priced into the interest rate markets in the US versus where we were four months ago, it’s wildly different. And at the same time, interest rate volatility is literally at generational lows. Equity, while people talk about equity vol, I think VIX today is 17. It’s low, I guess, in the context. But when you look at a percentile, like one-year vol over the last decade in equities, it’s about the 70th percentile. So it might be low, but it doesn’t mean it’s cheap. Interest rate volatility is literally at, like, 2, 1, you know, 0.

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