Nancy Davis founded Quadratic Capital Management in 2013 and manages the portfolio for the firm’s Interest Rate Volatility and Inflation Hedge Exchange Traded Fund. Forbes Senior Contributor William Baldwin outlined her career and the establishment of this novel ETF in this September, 2019 article.
After the extraordinary volatility of all markets in March of this year, I wanted to follow up with Quadratic and see how the fund with volatility in its very name had managed those historic few weeks. Nancy agreed to answer a few questions and here’s how it went:
John Navin: What’s stagflation? Why should investors be concerned now?
Nancy Davis: Stagflation is an economic condition in which slow economic growth (or even contraction) occurs simultaneously with rising prices. I’m sure there’s a better definition but that’s pretty close.
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Stagflation is a disastrous outcome for investors. Higher prices coupled with lower growth is a potentially terrible environment to generate positive real returns. With the virus curtailing economic activity while simultaneously disrupting and altering supply chains around the world, we could see prices for many goods rise even as the economy slows.
Policy changes that result in reductions of international trade or immigration could also be catalysts for stagflation.Investors might hope that a large bond portfolio would provide some protection in this stagflation environment, but stagflation could be difficult for holders of fixed income instruments.
Bonds could be just as likely to sell off as equities, foiling the popular “risk parity” strategy.
Quadratic Interest Rate Volatility And Inflation Hedge ETF daily price chart:
Navin: With oil prices in deflationary mode, how might inflation arise anyway?
Davis: The decrease in oil prices create a onetime deflationary shock. It is not recurring. We may see rising prices in other parts of the economy as supply chains are disrupted. Rising food prices are one example that come to mind. I’ve read about potential shortages of meat and dairy products, for example.
An economist would say that a reduction in supply should lead to a rise in the market-clearing price. Trade tensions and economic policies that prioritize national self-sufficiency could also contribute to inflationary pressure. I’m not making a prediction on inflation.
Our products don’t need a hyper inflationary environment to perform well. I believe we are among the top 5% of all ETFs in performance year to date and there’s not a lot of inflation right now.
Quadratic Interest Rate Volatility And Inflation Hedge ETF weekly price chart:
Navin: Without giving away secrets or getting too technical, how do you construct an ETF for stagflation?
Davis: In a period of stagflation, one could expect increased volatility, rising prices and higher inflation expectations. IVOL’s TIPS and options might do well in stagflation if the interest rate curve is likely to steepen and volatility increases in such an environment. We certainly do not hope for a stagflation scenario in the US, but, under such an interest rate scenario as described, IVOL’s portfolio may help.
Navin: What’s the market for your ETF? ? Mutual funds? Ordinary investors?
Davis: We have a diverse group of investors in IVOL. We have seen other fund managers use the fund.
IVOL is also an ESG fixed income fund. The ETF is an inflation protected bond strategy that is innovative and unique. We embody democratization of financial markets by providing access to inflation expectations for our shareholders.
TIPS only give you the CPI basket – it’s today’s inflation basket per the US government. Whereas IVOL gives you CPI with TIPS and the enhancement with inflation expectations given that the yield curve is largely a result of investor’s expectations for inflation in the future.
Also IVOL maybe a potentially attractive addition to a portfolio looking for diversification during a time when many other holdings may have behaved very similarly.
Navin: Average daily volume of your ETF is 47,000 shares. This is relatively low. What are your plans, if any, for increasing liquidity?
Davis: The secondary market liquidity is an important number to watch, but it does not properly reflect the underlying liquidity of the ETF. As the fund grows, I expect the secondary market liquidity to improve over time.
Institutional investors can achieve ample liquidity in IVOL. One can access massive liquidity by using the primary markets in ETFs. It is called “NAV based creates” or “NAV based redeems” for buys and sells respectively. That way investors execute their order in the primary market at the NAV (similar to a mutual fund).
I have been in the industry since 1998 but was not aware of this “technology” for trading until I learned about ETFs. And keep in mind that the fund is less than a year old.
Navin: Your ETF experienced the volatility that hit all markets in March. What’s different about “interest rate volatility?”
Davis: We have long been advocates for owning volatility, but IVOL is not a standard “long vol” product. An investor who is convinced of the benefits of owning volatility still has other decisions to make. Market commentators (and even sophisticated investors) often lump all long volatility into the same bucket. IVOL is one of the few ETFs available today that use interest rate volatility instead of equity volatility.
Equity volatility is generally limited only to options on USof the major drawbacks of any option is the negative carry. All options suffer from time decay and decline in value as time passes, all else being equal. But interest rate options have one factor that makes them different from equity options: the concept of rate roll down.
In the interest rate market, the forward rate can be significantly different from the spot rate. In the case of the options held by IVOL, whenever the interest rate curve is upward sloping, then the rates roll down could be positive and might improve the carry of the options.
This means that under these market conditions, the interest rate options owned by IVOL could have their negative time decay mitigated partially or completely by the roll down in the interest rate curve.
Of course, the inverse would also be true: if the curve is downward sloping, then the rates roll up would be an additional hurdle for the options. Historically, the curve has had a positive slope most of the time, making the positive roll down more frequent than the negative roll up.
Navin: A classic inflation hedge has been gold. Why might your ETF be an improvement over the barbarous relic?
Davis: No one gets paid coupons or dividends to own gold. It actually has storage costs which are a drag on the long run performance. This is probably OK when interest rates are very low, like now. But I would rather own things that don’t cost me money to own them. I don’t want to predict the future and anything could happen, so it is always advisable to have a diversified portfolio. Gold could be a piece of a portfolio.
I do not hold positions in these investments. No recommendations are made one way or the other. If you’re an investor, you’d want to look much deeper into each of these situations. You can lose money trading or investing in stocks and other instruments. Always do your own independent research, due diligence and seek professional advice from a licensed investment advisor.
My Marketocracy work is profiled in The Warren Buffetts Next Door: The World’s Greatest Investors You’ve Never Heard Of by Forbes Investments Editor Matt Schifrin. I’m a graduate of the University of North Carolina.