Episode #364: Nancy Davis, Quadratic Capital Management, “Some Women Like To Buy Shoes And I Love To Buy Options”
Guest: Nancy Davis is the founder and managing partner of Quadratic Capital Management and portfolio manager for The Quadratic Interest Rate Volatility and Inflation Hedge ETF (NYSE Ticker: IVOL). She began her career at Goldman Sachs where she spent nearly ten years, the last seven with the proprietary trading group where she rose to become the Head of Credit, Derivatives and OTC Trading. Nancy was recently named by Barron’s as one of the “100 Most Influential Women in U.S. Finance.”
Date Recorded: 10/13/2021 | Run-Time: 59:59
Summary: In today’s episode, we’re talking all things inflation and options with a self-proclaimed convexity snipper! We start by hearing how a conversation with Cathie Wood opened Nancy’s eyes to the benefits of the ETF structure. Then we discuss Nancy’s IVOL product, which has over $3.5 billion in assets in less than three years, and how it may serve as a valuable portfolio diversifier. We hear what she thinks about the recent Fed commentary, what the yield curve is pricing in today, and what her thoughts are around inflation as we wind down 2021.
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Links from the Episode:
- 0:00 – Sponsor: Public.com
- 0:50 – Intro
- 1:35 – Welcome to our guest, Nancy Davis
- 3:15 – Early thoughts on risk management
- 6:44 – Shifting away from buy and hold
- 9:53 – Starting Quadratic post-financial crisis
- 12:54 – How a conversation with Cathie Wood introduced Nancy to ETFs
- 14:55 – Having an entrepreneurs optimism and launching IVOL
- 21:51 – Analysis of their spread and the curve they look at for their product
- 25:24 – Nancy’s thoughts on the yield curve today
- 28:13 – Sponsor: Public.com
- 29:30 – Is IVOL a bond substitute, alternatives or a fixed income fund?
- 34:43 – What types of environments would make this fund’s performance struggle?
- 37:46 – Other ways to integrate this fund into your portfolio as a tradeoff or hedge
- 39:33 – Any future thoughts to explore other options and new products
- 47:20 – T-Bills, Cryptocurrency, and diversifying your portfolio risk
- 51:22 – What the horizon looks like for Quadratic over the coming decade
- 53:00 – How investors should be thinking about yield with their strategy
- 54:50 – Nancy’s most memorable investment
- 56:23 – Learn more about Nancy; ivoletf.com
Transcript of Episode 364:
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Meb: Hey, everybody. Today bomber show, our guest is the founder of Quadratic Capital Management and Portfolio Manager of the Inflation Hedge ETF. In today’s show, we’re talking all things inflation and options with a self-proclaimed convexity snipper. We start by hearing how a conversation with Kathy Wood opened our guest’s eyes to the benefits of the ETF structure. Then we discuss our guest’s IVOL product, which has over $3 billion in assets in less than 3 years, and how it may serve as a valuable portfolio diversifier. We hear what our guest thinks about the recent Fed commentary, what the yield curve is pricing in today. And what her thoughts are around inflation as we wind down 2021. Please enjoy this episode with Quadratic Capital Management’s Nancy Davis.
Meb: Nancy, welcome to the show.
Nancy: Thanks for having me.
Meb: Well, it’s great to see you. Where in the world are you today?
Nancy: I’m in Connecticut.
Meb: Sweet. Well, I am in California. We were just rapping before, I was camping up the coast and got fire evacuated. It was on a Hipcamp farm and started getting these pings on our phone that said you may want to get out of here. It feels like a very 2021 thing, this global warming and California fires. But look, you and I crossed paths, perhaps, we don’t know. We both went to school in the same part of the world. Rewind us back, you weren’t always a volatility options guru. Like, George Washington up the road. I went to Virginia, probably saw you on M Street one of these days. Is that right? What did you study? Were you a scientist? Did you like options at that point in the world? Did you know what options were?
Nancy: I did. It’s actually kind of funny. I was a scholarship kid. I had a full-time job all through school, that’s actually how I got into all of this derivative stuff was through my job. I worked at a management-consulting firm and we were doing all this transfer pricing and I was like wow, what are these swaps? And how does it work, this swapping revenue from one country to another country for tax reasons? And fortunately, I was in the honor program so I could take classes in any of the universities. So I actually ended up taking five grad classes as an undergrad and got super into options. And it’s probably how I made my way into Goldman Sachs as a non-Ivy League kid was I had a lot of option training on my background as an undergrad.
I always joke that some women like to buy shoes and I love to buy options. So you got to do what you love.
Meb: And to take us back, you and I would have been cutting our teeth in the early stages, late-stage, excuse me of my favorite bubble bull market, the internet dot-com explosion of the late ’90s. Do you have any memories of that time? Because I remember very fondly being in class and having professors that were straight-up checking quotes during class. They would actually talk about their investing portfolios and how much money they were making circa late ’90s. Was that an experience you recall? Or was it just easy street, you just bought options back then and just cashed the checks? What were the memories?
Nancy: Well, I always thought about risk management a little bit differently. I kind of always thought most people construct a portfolio with linear instruments like stocks and bonds and then they might manage risk using options either for coloring the position or hedging the periphery. And so for me, I kind of always thought that was like the wrong order of operation. It’s like in math class, if you remember, you get an equation and it might have the subtraction first and the formula but you can’t be tricked, you got to go to the division first. I feel like a lot of people just have risk all backwards and that most portfolios are managed using stop losses. That to me just sounds stupid. It’s like, first, you lose your money and then you manage risk. And so for me, using options made a ton of sense, I think it just clicked.
That’s the way to do it, like, stop loss when you put on a position not after you lose money. And stop losses, you’re constantly buying high, selling low to manage risk. And I like using options, especially long options, your long gamma, so you’re constantly buying low, selling high. So for me, it made a lot of sense, it resonated, and I happen to love it, which is a good thing. I do a lot of teaching at colleges and universities and I always tell the students, like, find something you love to do, something you literally do in your free time and try to make a career out of that.
Meb: It’s interesting you touch on a couple things that are, I think, pretty insightful. The first being is that it’s interesting how you were sort of…like Buffett talks about being inoculated at an early age to a particular style. And for a lot of people…for me, it was like, the way I eventually arrived at our styles was, like, doing the wrong thing over and over. Like doing something extremely painful having a scar saying, “I don’t want to ever do that again.” But it’s funny you talk about the stop losses, I mean, again, this is going back 20-plus years ago. But I remember being late ’90s, I had also arrived at a methodology, which was a long-short portfolio and I would short all the IPO lockups. So this is late ’90s, all these similar to today, you would have a lot of companies going public that just got kind of barfed out. And then as soon as the lockup happened six months after the IPO, everyone would just mass sell. And so that was my methodology to stay hedged.
So like, the defined buy and sell criteria you’re talking about. Exception of, I didn’t have time to put in all my shorts and sell orders before going to spring break. This would have been the year 2000, Jamaica, it was probably worth it in retrospect. But that’s when…I was a biotech guy. That’s when all the biotech stocks cratered when one of the Clintons, I forget if it was Bill or Hillary, made a speech about you couldn’t patent the genome. But it goes back…like it’s funny, you look back at the time, say, what’s the catalyst? And often the catalyst is never that important, it’s just something we ascribe in the past.
But long-winded aside, you hit upon an interesting topic. And you arrived at this at an early age, which is…everyone I talk to spends 99% of the time today focusing on the buy decision with no sell concept, they just kind of wing it. They buy something, buy gold, buy Amazon, buy Dogecoin and there are no sell methodology. Yours is kind of baked-in, which is what you’re talking about, this sort of stop loss. Could you unpack that a little more because, to me, that’s a pretty profound thought process?
Nancy: Yes. So very simply, you manage the market value of the options exposure. So in all of our portfolios we have a set amount of exposure and when the strategy makes money, we’re constantly profit-taking. So as the position gets bigger, we’re selling high, selling high, selling high, and when the position goes against us, we’re buying low, buying low, buying low. So it’s always that active management of being the best fiduciary we can be and doing what’s in the shareholders’ interest.
And I think you really have to have an ETF format. A lot of ETFs are passive, especially in the options world because most strategies are selling options someplace, right? They might be selling upside calls, or they may be selling downside puts or collaring markets. But when you’re long-only options, you need to manage it. You can’t just sit there and say, “I hope at the end of the month, the market is in this place.” You want to be able to trade intermonth.
And so I think having that active aspect of our portfolio really helps with that long optionality because we can use the pullbacks intermonth to add to positions. We don’t have to sit and wait until the index rebalances or there actually is no index. I think it’s one misconception is a lot of people think of indices as these broad-based, market-based, kind of, all-encompassing things. And there’s been so much passive indexing since the financial crisis, especially with fixed income.
I think a lot of people just don’t realize how much of like, say, the Agg Index, it used to be the Lehman Agg, and then it became the Barclays Agg, and then it became the Bloomberg Barclays Agg, and now it’s just the Bloomberg Agg. But that index is an old index, it’s crazy old. It was invented before the U.S. Treasury invented the TIPS market, the inflation-protected market in the late ’90s. So that index, although many people think of it as core fixed income, it has no inflation protection, and it’s only short fixed income volatility from the mortgages.
And I think that’s another misconception is a lot of people don’t realize in their fixed income portfolio most of them are short volatility. And that’s because homeowners in the United States are long the option to prepay. If you have a mortgage, you can prepay it whenever they want. If you own the mortgage, you’re short the option to the homeowner. That is called prepayment risk, or there’s lots of…I call it G-rated names to say short volatility. But what that is, is most investors are short volatility in fixed income. And so that’s why we created the IVOL fund to not just have only short convexity in fixed income to have also a way of having long convexity.
Meb: We just cannoned-balled the deep end of the pool so let’s lay some foundation. So you spent a career on Wall Street at some traditional desks, Goldman, Highbridge, Bernstein. And then at some point, you said, hey look, I want even more pain and challenge to be an entrepreneur. Walk us forward. This is … the timeline, post-financial crisis, I believe, starting Quadratic. What was the crazy decision there, and what was sort of the idea and thesis?
Nancy: Well, I didn’t think it was a crazy idea. I just really thought it was a great idea. And I guess all entrepreneurs need to have a little bit of the optimist and blissful thinking. I thought this is a slam dunk, of course, I should start my own firm. Quadratic has been running for over eight years now. It’s been amazing. I feel like I’ve also pulled in so many other entrepreneurs to start their own business in all different sectors, I’m really proud of that. When you experience, kind of, the benefit of working for yourself and creating something from scratch, I think it’s just so exciting and you want to get other people involved.
I had a little bit of I’d say a different path. I’ve always been, you know, a little bit of a different thinker going back to using options in college even in my P.A. But I was actually a stay-at-home mom for three-and-a-half years. So after the financial crisis, I had a really great payout as a long vol person. I was very lucky, made more in ’08 than I had ever made in my life. And I decided because my kids were all…both of them are under 3, they were still home all the time. I was totally outsourcing being a mom. I was never around during the week, it was basically the weekends only. And so I decided to be a stay-at-home mom. And as an investor, I think it was the best use of time. And I was home with my kids until my youngest started kindergarten, then I came back to my career.
And I think having that break, in a way, is what gave me the freedom and the confidence to start my own firm because I knew I was employable. Like, I wasn’t scared that I wasn’t going to be able to get a job again if I created a business and say it didn’t work. And so I think in a weird way having that going from soccer mom to reporting to a big public company owned by a French insurance company was a great step for me to give me that freedom and confidence to be like, “I can do this, I got this.” And I always try to tell people that I meet in the industry who are thinking about starting a business is I always say, “Just go for it. If you’re good at what you do, and you believe in what you do, and you’re solving a problem for people…” I think that’s also key is you want to give a solution to something that people are facing.
It’s awesome to do. I love the ride, loved every aspect about it. I’ve had to do, I’m sure like you, a ton of things that you’ve never done before, right? It’s like, I’ve never been a CEO before. I was a portfolio manager, I manage my options positions. It’s a lot of new things but it’s exciting, too.
Meb: So congratulations, you’ve not only survived, which is like the big part we tell everyone, but also thrived. Was the original vision to kind of start to launch some ETFs in the public structure, or did you say, hey, look, this is the research and idea. I’m not quite sure what the product is going to be, whether it’s going to be separate accounts, private funds, or insurance, who knows what? Because it’s obvious now, I don’t know that 10 or 20 years ago it was obvious that certain ideas and products and ETF structure would see the reception they’ve had. And so you’re a bit of a pioneer in certain areas. We see so many of these firms just throwing everything against the wall, these me-too products. But then you see things like you’re launching which are a bit different. Was the ETF sort of a gleam in the horizon or was it always the, kind of, goal when you started things up?
Nancy: I was definitely very, very late to the party with ETFs. I did not realize how cool they were, I didn’t really understand them. And shame on me because I was at Goldman for a decade almost. I was on the prop desk, so managing Goldman’s own capital. And I sat right next to the program trading desk that later became the ETF desk. And so I should have known before what ETFs were and how great they are. But I really didn’t get exposed or understand how interesting they are. I always thought of them as retail products.
And as a fund manager and a portfolio manager, I’m like, boring. I have no interest in doing the same thing every day being a machine rolling at the end of the month to the new at the money option. Like, it didn’t have any appeal to me. And then I learned about the world of active ETFs. And that was really from my colleague and my dear friend Cathie Wood who I met at AllianceBernstein. And seeing what she did with active ETFs, I was like wow, this is a commingled fund and it’s actively managed. It’s the exact same thing as what I was doing previous in the private fund wrapper as the same portfolio management, the same…everything was the same except the fees are so much better and lower for investors and then the tax efficiencies.
Meb: All right, well, let’s walk it forward now. So you’re scratching your head and say, look, I got this idea. Did you have any sort of…because I feel like there’s a couple different models when we talk to people who launch ETFs. There’s the one where you have a big fat seed where somebody is like, “Look, I got $500 million, launch this fund.” Or you have maybe a bunch of accounts that you cannibalize. You see it’s starting to happen more and more with advisors and other people saying, “Look, I got $100 million in the strategy across 1,000 accounts, why not just be an ETF?” Or is it just total blue ocean bootstrap starting from zero? You say I got an idea I am going to see if anybody else wants it. I think they will because I like it and it’s brilliant but you got to educate the marketplace. Like, where did it fall in under this spectrum of having, as I like to say, the naive optimism of an entrepreneur to believe that the world thinks like you do when there’s nothing else out there quite like it?
Nancy: I think it was the latter for me. It really started in 1998. And I remember being a young new trader at Goldman, and looking at the inflation-protected bond market and being like, “This is so stupid, why would anybody put all their chips on one index to measure something as big as inflation?” It’s like, in the equity world, you would never buy the Dow Jones Index and be like, “Hey, I’m done I got it, I got equities.”
Meb: It’s funny you say that, however, because there’s still a gazillion dollars somehow indexed to the Dow, which I don’t know how. It’s 2021, it’s up there with one of the all-time most nonsensical indexes, but people still do it. I mean, who knows?
Nancy: I can’t explain that either. But for something like corporate America, right, so the stock market, the corporate bond market, it’s only so big. There are ore ETFs and public companies now supposedly. And inflation is, like, a much bigger, harder to measure things. So using just the consumer price index to measure inflation always kind of bothered me from early on in my career. And so when we created these ETFs, like when we launched the IVOL ETF, it was really a solution to give investors the TIPS market plus another measure of inflation that’s not linked to CPI. I think many people are really surprised to learn that CPI, the Consumer Price Index, is calculated by the Bureau of Labor Statistics. Like, that should say it all.
But a third of it is shelter. And a shelter is actually owner-occupied rent so it’s not super relevant for many investors. And we’ve had a lot of success. IVOL is not even three years old yet, and it’s actively managed. So a lot of it is waiting…I don’t know why, maybe you have a reason for the stupidity. But I don’t understand why everybody waits for three years for active ETFs. It’s just like, is three the magic number? I don’t get that. But we’re not 3 yet and the fund is over $3.5 billion. And a lot of that has been institutional investors who are like, yes, that makes so much sense, why would we just use CPI swaps, which are linear exposure to the same CPI index, or use breakevens, or use the TIP markets, or use commodities or other things to get inflation exposure?
So I think it’s really seeing a problem that’s always kind of bothered me over my career. And also, TIPS are long duration. So if you look at the first quarter of 2021, yields went higher, long-dated yields, because everybody was talking about inflation and TIPS lost money. So I feel like we’ve come up with a really elegant solution to potentially make money when long-dated yields go higher when the bonds lose because of the duration exposure. So IVOL had almost 400 basis points of outperformance in the first quarter because we had interest rates go higher, everybody was talking about inflation in the first quarter, right? It was on every financial news channel you turned on, people are talking about inflation. And here we have the inflation-protected bond market losing money. So I feel like it’s just really trying to problem solve and give investors a better solution. And I think the TIPS market is pretty broken and it was pretty easy to innovate and make better for investors.
Meb: Let’s take a step back for the listeners who are not familiar with IVOL. Give us a broad overview of this strategy. What are you guys trying to do? And it’s actually kind of interesting because your career, if I get my history right, sort of coincides with the launch of TIPS in the late ’90s, right? Like, wasn’t it late ’90s the U.S. sort of launched TIPS? Tell us a little bit about the IVOL strategy. What were the goals? What’s the construction? Give us the, kind of, broad overview.
Nancy: You’re absolutely right, Meb, it starts with my, kind of, seeing the inflation-protected bond markets starting in the late ’90s, noticing that so many passive indices don’t have any inflation protection in them because they’re old indices and they were created before the Treasury invented the TIPS market. And trying to give people a way of completing their portfolio to have…say you have the Barclays Agg, or a manager that’s benchmarked to the Agg, you don’t want to have no inflation protection. And just using TIPS alone don’t give you a broad enough measure of inflation. So it was really a solution to having TIPS be long duration and having the only measure being CPI, giving investors another measure of inflation expectations.
Meb: And so tell me how it all comes together. Today it was actually CPI day, I think, or it’s somewhere in mid-October. Tell me how this whole strategy comes together into a format, like what’s the construction, and what’s the end goal for the investor?
Nancy: Well, for me, the end goal for fixed income investors, for people who want to buy bonds is twofold. It’s diversifying your equity risk and pays a monthly distribution, period. It’s very, very simple. And I think we do that with the IVOL ETF, but just in a different way than most other strategies. And to your point, there are a lot of me-too strategies that are doing exactly the same thing, or the index plus or minus 25 basis points. We really saw this as a way of giving another spread product. We don’t take corporate spread risk. Like, there are only two types of bond risk, interest rate risk or spread risk. Mortgages are agencies spread risk over governments. Bonds with credit exposure like IG investment-grade high-yield bonds, levered loans, all those things have corporate spread risk.
We just do something different; we take interest rate spread risk as a way of looking at inflation expectations not measured by CPI. Because if you think about the central bank, the Fed sets policy rates, but where interest rates are at different points in time is where lenders lend money. And that’s largely a result of inflation expectations in the future. So we see it as a broader measure of inflation, and another spread product that’s not just using corporate or agency spread.
Meb: So when you think about spread, what is the curve you’re looking at for this sort of product?
Nancy: So we’ve looked at the spread between interest rates where lenders lend money as a very…it’s sometimes called the term premium, some call it the yield curve. It’s where if you go to a bank today and you lock up your capital for, say, two years, you get paid close to nothing. Because the Fed hasn’t started hiking rates so there’s maybe a little bit of hikes being priced in in the next year, but it’s pretty much very, very low.
If you lock up your money for 10 years, you get paid only about a percent more. And that is crazy to me. That is…because lots of hikes have been priced into the front end of the curve, and then a lot of people have been adding to duration. Meaning, I think about Q2, the 10-year treasury was 175, that’s not like high or anything. And then we’ve had all these CPI prints since then that are in the five handle. Like, why would you go get a negative real return even with that measure of inflation? So all we do is look at inflation expectations not measured by CPI and that’s what we add into the portfolio.
Meb: So is it broadly like a 10/2? Like, I feel like that’s…when you talk about yield curve everyone like talks about 10/2 or 10/90-day, or 30/2. Is there, like, a sort of broad reference range you guys are looking at?
Nancy: Yeah, for inflation expectations we like to look at the 2 year/10 year, but we don’t look at the treasury curve. That’s the one thing to keep in mind is that there are a lot of different yield curves. There are a million different U.S. dollar rates, there’s LIBOR, there’s SBAR, there’s treasuries, there’s swaps. So the Fed really controls the treasury market, right? A third of the treasury market is owned approximately by the Fed. So you don’t…because we want this thing to move, we want it to be like the wild stallion, we want something that is not as controlled by the QE purchases. So that’s why we use the CMS market, which is a type of interest rate. So it’s always that difference between the 2-year and the 10-year rate at the point in time because the options we buy, they don’t expire today, they expire in the future.
And so that’s how we capture the risk-off environment. So in equity selloff, a lot of equity investors, they want their fixed income portfolio to diversify their equities. And the way our strategy works is it’s long duration from the treasuries that we own. It’s long vol because we’re always long-only options so it’s long fixed-income volatility. And it also can benefit from less hikes in the front end of the curve. So that’s why we’ve had less of a drawdown when TIPS by themselves have sold off because we get that risk-off with the Fed cutting rates, or if the Fed went to negative rates, or if the Fed hikes less than what the market is pricing in. And there’s a lot of hawkish talk that’s been coming out of the Fed since the June meeting. It’s I think very, very hawkish talk since…
Before the June FOMC meeting, the Fed was saying, Powell was saying, “We’re not even thinking about thinking about raising rates.” And then in the June meeting, we got this surprise with the dot plot showing all these hikes. So four hikes have been priced in to the front end of the curve before the end of ’23. I think that’s pretty aggressive, especially with the taper likely coming this year, plus the midterms in ’22. Plus six of the FOMC members are likely going to turn over, including potentially Powell himself.
Meb: So where do we stand today on that sort of curve? I mean, my expectation or guess is that it somewhere waffles between, sort of, zero, rare occasions negative, up to around two, three. Is that, sort of, the broad range-ish? And if so, where are we now? What’s it telling us? What’s it excited about?
Nancy: So the difference between the 2-year and the 10-year rate right now is a little over 1%. So you lock up your capital for 10 years, you get paid a little over 1% more. We think that’s pretty attractive. And also, the forward, which matters more because we own options that don’t expire today, they expire in the future, the forward is even lower than that. And that’s because of all the hikes in the front end. So it’s been…we’ve actually experienced the biggest forward flattening in the yield curve since the financial crisis after the June FOMC meeting because it’s been killed on both sides. Because you’ve had duration has been bought so long-dated yields have gone lower, the 10-year has gone lower. It’s been bonds have been bid because people are saying, “Oh, the Fed is more hawkish, it’s safe to buy duration.” I don’t really get that. I feel like they’re just saying we’re actually having inflation so we need to hike more.
And then the front end has gone higher because you have so many hikes that are priced in. I’m just looking at my Bloomberg right now, you have 5 basis points of hikes being priced in this year in ’21. And almost 2 full hikes being priced in, in ’22, in addition to the taper. Plus, there’s another 69 basis points, so more hikes being priced into ’23. So there’s a lot of, I’d say, juice there. That’s what the market is expecting, and what the market expects often does not happen. Like, the best example I can think of in recent memory would be, let’s say I think it was December 18, if you remember Trump was in office still. And right before the December FOMC meeting, he was tweeting about ..Jay…basically trying to get him to be more dovish.
At that point, the rates market had priced in three hikes in 2019. And what actually happened? We cut three times. So the rates market the expectations are often wrong. A lot of it is macro tourists who hear, “Oh the Fed is hawkish,” and then they go and buy bond puts, or Eurodollar options, or other ways of expressing that view, not really realizing what is priced into the market. I think you made a comment before about people think about where they buy and not where they sell. Well, a lot of people in the rates market are not thinking about what is priced in that they’re buying, right. You can’t hear hawkish comments and just blindly go short bonds because you have to look at what’s priced in. So it’s all about expectations, not what actually happens.
Meb: That’s a great point. Walk us through a little bit how to think about including this into a portfolio. I know when people traditionally think of inflation that I talk to, they often think of real assets like real estate, they think of commodities sometimes, sometimes gold if they’re a little askew. I’m joking to my gold friends. Where does this fit into a portfolio? Is it a bond substitute? Is it a real asset substitute? Is it an alternatives bucket? Is it a what?
Nancy: It’s just a fixed-income fund, it’s nothing…I’d say it’s literally a mirror image of a mortgage. If you think like, what is a mortgage? It’s an agency obligation coupled with a series of short options if you own the financial mortgage because homeowners are long those options. IVOL is a treasury obligation, meaning the TIPS that we own, the treasuries with inflation protection, and a series of long options. So I don’t really think of it as anything different than that, it’s just a different type of spread risk. Instead of taking agency spread risk or corporate spread risk, this takes interest rate spread risk, which it’s good to be different in this world because you want stuff that’s not going to be correlated with itself.
And IVOL, if you look at like the IVOL ETF website, the fund website, and we have our fact sheet there. And you can see it really hasn’t, at least historically, had a lot of correlation to stocks and bonds and that’s because it’s something different. So correlations can always change. But you often hear about people talking about the unwind of a 60/40 portfolio, like, that does concern me because 60/40 has worked for so long because we’ve had this bond rally. What happens if we have stagflation, for instance? I think that would be the worst possible outcome for 60/40 because you would likely lose money on stocks and bonds all at the same time. And so I know we have a lot of endowments and other institutional investors that own IVOL inside their portfolio, just in case there’s stagflation, or just as a diversifier within their fixed income bucket.
Meb: I was actually looking that up on Google Trends to see what the stagflation trends are looking like. It’s picking up, hasn’t broken out yet, but it’s definitely picking up.
Nancy: It’s all when you buy it, right? No, just kidding, it’s when you sell it too.
Meb: Yeah, exactly. Who would have been the early adopters? It’s fun listening to small conversations you’ve had over the past few years where you’re chatting, and the host is like, “Nancy, congrats, you made it to $100 million. It’s amazing.” You’re like, “I know, I’m so excited.” And here we are now adding a few more commas. Who have been the adopters? This is a strategy that, on its surface, you start to mention things like just starting with TIPS, and then things like swaptions and yield curves, and on and on. It’s a language that a lot of people historically aren’t as comfortable with. Is it advisors? Is it institutions? Is it individuals? Are those conversations different and do they use it in different ways? What’s the, kind of, early adopters thus far?
Nancy: Yeah, it’s a little hard to tell with ETFs. But I think a lot of our early adopters for other fund managers, we had a lot of specialists to look at. Like, say you’re a high yield bond manager, you’re used to looking at companies, you look at corporates, you’re a sector analyst, you look at cap structure. This is something different, this is not corporate risk. And so I think a lot of the early adopters, I would say, like, professional fund managers who are buying this because it is different than corporate. So it is giving you access to another market. A lot of the mortgage guys really got it quickly. And I know it is a different product. But I don’t really think it’s much…like, a mortgage is super complicated because you have to model thousands of short options because of that prepayment risk with mortgages.
And so I feel like IVOL, in a way, is really simple because it’s fully funded long options, it’s not plus treasuries. So there’s never an obligation on the fund above and beyond the premium that we pay. And so, in a way, it’s a really simple, long-only strategy. It’s just a different kind of asset class for most investors. Because most people have stocks and bonds in their portfolio and the bonds that they have are either bonds with government risk or credit spread risks. Like, floating rate notes, leveraged loans, high yield bonds, investment grade, all corporate risks. Or they have mortgages, which are agency risk.
So it’s just something different. And I would say we’re not marketing it to retail investors at all. We do, I think, have some now that…once IVOL crossed our one-year birthday and we did win the best new Fixed Income Fund of 2019, which I think put it on the map for a lot more financial advisors, and then they can look at their client portfolios and see if it’s appropriate for their clients. And we’ve tried to do a lot of education too, writing white papers. We also named the fund, like, it’s a mouthful. People always comment on it’s called the Quadratic Interest Rate Volatility Inflation Hedge ETF. I mean, it’s like probably the longest ETF name ever. And we want people to understand it, we want them to know what it is. And so we do spend a lot of time on educating investors to what it is.
Meb: Every strategy has its time in the sun, time in the shade. When would this strategy potentially stink it up? Is it a deflationary environment, is it an environment where the yield curve collapses? Hopefully, we don’t see it. But when might it struggle?
Nancy: Definitely if we have deflation in this country the fund would struggle. If the Fed gets…if they are as hawkish as they’re talking about and they do hike rates that much, I don’t think the financial markets…I feel like they’re higher than the real economy. We’ve had a lot of financial price inflation, not real economic growth. So I think if the Fed got crazy hawkish, did hike a ton, and that would likely make equity selloff, and credit spreads wide, and a lot of people would run into long-dated bonds, nominal bonds, that would be a bad scenario for the fund.
But the good scenarios are multitudes. It’s long option so you get the or, you get this or that. And so I think in an equity risk-off environment, this could potentially do well because it’s long vol and because it’s long duration, and because we can do well if there are less hikes. It’s also a neat inflation scenario, which is typically risk-on, as another measure than CPI, and it’s also potentially good stagflation. Although, we haven’t had stagflation since the ’70s, and IVOL didn’t exist then so it’s hard to tell. But I think it would do well in a stagflationary environment because I think likely interest rate vol would be a lot higher. I think credit would really underperform in that environment, and TIPS would outperform regular bonds. And I think the yield curve would likely steepen, especially given how many foreigners own dollar-denominated debt that they would demand more yield if we were not growthy and just had higher prices.
Meb: I was laughing as you were saying IVOL didn’t exist, you and I didn’t exist either. Like, if you look at the challenge a lot of…I feel like with markets is, you see a lot of things that rhyme over time. And often by the time the people who are managing money are managing money, they often get surprised by the event that hasn’t occurred in their lifetime. And so, for us, certainly, we haven’t really been through that sort of ’70s environment. We haven’t been through a lot of different environments, 1930s as well.
Nancy: But I feel like history just repeats itself. It’s always just…it’s a different underlier. Like the ’70s, we had stagflation because of the oil embargo, right? Today, it’s not the oil embargo, it’s the labor force shortages, it’s the shortages of factories not working at full capacity. It’s the same exact thing, it’s just a different underlying problem that we’re having now. And it’s unclear whether it’s going to be stagflation or not. But you look at some companies as they report earnings and they’re talking about higher labor costs and productivity delays, and that could hurt earnings per share. And that could be really bad for investors who have stocks, and then also have their corporate bonds. Because if you have a company that’s losing money, typically credit spreads widen when equities sell-off.
Meb: And corporate is just an interesting world with some of these junk and others coming down to near all-time lows. I mean, as you were talking about that, I was just thinking back to yesterday…by the time this comes out, this could totally be a different world, of course, in a week. But was filling up the car and it was darn near 5 bucks in L.A., which is starting to get to the point where probably it’s going to cause people some real pain.
So if you talk to, say, a traditional allocator, or an endowment, or someone who has a pretty diversified portfolio, so not just like 60/40 U.S. but somebody who’s got a little bit of everything…this obviously isn’t advice, yadda, yadda. When you slot this in, you mentioned earlier like, is it the most appropriate, sort of, sell about treasuries? Is it selling TIPS? Like, if they already have TIPS, do they sub this out? Is it part of the real estate? Is it a little bit of everything? Or is it just like, it depends, it depends on your philosophy and framework? I mean, I know we touched on this a little bit, I just like to get a little more of your thoughts on this because people I think are probably going to be interested in how to use this and wondering what to do.
Nancy: It’s interesting, you could definitely use it as a TIPS replacement, you could definitely use it as a potential equity risk-off trade. You could even potentially think of it as maybe a hedge for real estate because real estate tends to be very sensitive to long-dated interest rates with mortgages. But interestingly, I think most people that I see that are really embracing the fund like it because it’s not credit. So I think the more investors think credit spreads are very, very expensive and they don’t want to take…they’d rather take their corporate risk in equities and have the upside.
I think the more people hate credit, the more they tend to like IVOL. So I feel like often the prettiest girl in the room because they just don’t like everything else more.
Meb: Yeah, this methodology and mindset…over the last few years, you’ve had conversations with a lot of the gatekeepers, I could do an entire podcast on the nonsense there, my goodness. But as you think about…like, do you get feedback where you’re talking to an institution they say, “Oh, Nancy, brilliant product, can you launch something like this on the global stage?” Or maybe not just U.S. focus, but maybe international? Are there other…? Because often as we launch funds, we often say we launch funds that Meb wants and ideas that our company thinks are great ideas, and then it gets out in the market and floats around for a while, and then people give us feedback. And you get the feedback of the tens, or hundreds, thousand investors. What have you thought about as far as the horizon, is there some global ideas? I mean, I imagine you traded a gazillion different types of options and derivatives in your time at the various companies. Anything else on your brain? What are you thinking about?
Nancy: I definitely do love both markets but I think specifically for inflation expectations, I kind of think the U.S. is where it’s at because we have such negative real yields. And like the U.K. has gas lines and super negative yields and inflation is in all of their pension fund portfolios already, it’s mandated. In the U.S., nobody owns inflation. It’s like some people have maybe some infrastructure, maybe some cyclical equities, or maybe some commodities to gain exposure, but it’s wildly under-owned. And it’s also not very expensive, especially when you’re looking at what’s priced into the interest rate markets.
And I can’t imagine a market that would be better to…In our lifetime, there’s probably been…owning inflation protection has been a losing situation because we really haven’t had runaway inflation since the ’70s. But today we have this like…I feel like it’s like toxic cocktail because we’re having average inflation targeting being added. Then we have the fiscal spending, and then we have the labor shortage, and then we have the Fed talking very hawkish and likely going to have major turnover on who is on the FOMC. So I think it’s a pretty good opportunity.
And personally, I think that people really shouldn’t be making a bet about whether inflation is transitory or not transitory because we do live in a real world. There are real costs of living, you have to fill up your car even if gas is 5 bucks a gallon, you still buy it, right. And you still have to eat, and you still need your prescription drugs, and you still want to send your kids to school. Like, we live in a real world. And if you don’t have inflation protection in your portfolio, whether it’s IVOL or something else, you’re actually shorted because, in real life, we are sensitive to that.
So I feel like so many people focus on asset allocation to not have the portfolio all go down together at the same time. But inflation does that to your financial savings, especially if you’re not in the labor force anymore if you think about your personal balance sheet. If you’re not working, and say you’re a retiree, you’re not going to benefit from the wage increases, you’re just going to have a higher cost of living. So I think it’s one of those things that people really try to over pick about whether the timing is good, whether I should buy now or wait, or whether it’s transitory or not. To me, I think of it as more just an asset allocation that, hopefully, it doesn’t happen, hopefully, it’s all good, and hopefully, the Fed has a finger on keeping things in line. But what if they don’t? And just being prepared is super important.
Meb: The Fed governor is to busy day trading. As you mentioned, toxic cocktail, sounds kind of delicious. I was looking up some things while you were talking. There’s the classic…like, Thanksgiving is right around the corner. The Thanksgiving inflation where people do the traditional cost of Thanksgiving. We have an old article on the book, had this from 2013, the math is too long. There’s an old superhero, says the price of being Superman, then and now from 1938 to 2013, it’s a fun graphic, we’ll add it to the show notes.
TIPS haven’t been around that long in the U.S., you mentioned late ’90s. Existed in the U.K., Inflation-linked Gilt, since the ’80s. And I actually googled this and Wikipedia said there was once an inflation index bond issued by the Massachusetts Bay Company in 1780. That’s a fun stat, listeners. I don’t know what you can do with that, look it up later. So as you look around the world, we’re winding down 2021, what else are you thinking about? What’s up on your brain, anything you’re excited about, anything you are confused about, anything you’re scratching your head about, anything that’s keeping you up at night?
Nancy: I am a little worried about the tax situation, that is another thing that could potentially be bad for corporates is having higher corporate taxes and that kind of worries me a little bit. I feel like I want to stand on a soapbox and be like, “IVOL,” and tell everybody about it because you could just see a lot of scenarios happening where that traditional 60/40 portfolio may not work. And I think a lot of investors are sticking in short duration. Like, short duration personally freaks me out a lot because I think it’s one of those names that people don’t understand what it is. So if I can spend one second on my…there are only two types of bond risk, there’s rate risk, and then there’s spread risk. And so short duration doesn’t have a lot of rate risk because it has shorter-term bonds, but it has a lot of typically credit-spread risks.
And especially if you look inside of some of these fixed-income ETFs, they have CMBS, and ABS, and CDO and CLOs, and every type of credit acronym you can think of. And I do think that’s very risky for investors because imagine if you were the CFO or treasurer of a corporate, why would you be borrowing money short term in today’s environment, or borrowing money floating rate? It’s typically because you can’t afford to term it out. And I think hopefully investors had a little bit of a wake-up call with the whole Chinese bond payment recently in the news because, in a credit event, a shorter-term loan actually becomes more risky. Like, typically CDS curves invert just like the VIX because the company has to either amend or extend or they have to turn out their loan, or they have to make a payment. So your default risk can actually go up very quickly. And so I think one thing that really bothers me is I want to grab people and be like, short duration doesn’t mean you’re going to make money when interest rates go higher, it just means you’re going to lose less. It really should be called less long because short duration is still long duration, it just has less duration. And be aware of your credit spread risk.
For any of your viewers, we did a piece…we always try to do a thought piece in our letters for financial professionals. And I don’t like scary movies at all, they kind of freak me out. But I don’t know if you remember “It.” It was the clown in the drain. Every single time I turned on TV and…stupid, I can’t fast forward on the Smart TV, it like makes you watch the commercials, it was always a clown, and it was super scary. So in the inspiration from the meme stocks, I made a meme about the “It” movie with the red balloon being the credit spread risk. And so I’d be happy to send any financial professionals our letter talking about the risks inside short duration because it’s only two types of risk, it’s spread risk or its interest rate risk.
And if you don’t take a lot of this one, you might have way more. And we looked at ETFs, specifically short-duration ETFs, and a lot of them, 85% of the risk is BBB-minus credit or lower. So that’s something that does keep me up at night but I think people think of short duration as safe, and it really depends. If it’s governments, it tends to be safe. But if it has lots of credit spread or other type of spread risk, it may not be as safe as you think.
Meb: Yeah, you guys have a lot of good materials on your website. Talk to me a little bit…there’s a conversation I was having on Twitter into the darkness, about two years ago, almost where is an article we ended up writing during the pandemic, and people were focused on different things. So I think it’s…and it’s a little academic and wonky in nature. I feel like you talk a lot about some similar, sort of, Venn diagram ideas, which partially you can elaborate on here.
And then there are two ideas that I’m kind of thinking at the same time, the first being thinking about your human capital risks relative to your portfolio and what is not being addressed. One of which a lot of people when they talk about their safe money.
And this could be I think a big opportunity for a fund like yours is this entire treasury asset world where people just keep it in short-term T-bills. And we wrote an article about this and said T-bills historically…people don’t know this. We did a poll on Twitter said how much do you think these have declined on a real basis after inflation? Already you’re losing people on this, sort of, nominal versus real returns. And almost everyone said like 0% to 5% or 0% to 10% when the reality is half because of the eroding effects of inflation.
And so talking about…actually, if you think about what the safest asset is, it’s not historically T-bills. I wonder if something like IVOL could actually be thought of as a better treasury asset for corporates. So if you’re Apple, if you’re Google, if you’re Facebook, Amazon and you just load up on T-bills, obviously the same thinking applies to personal balance sheet for individuals. Oddly enough, this argument got co-opted by the crypto community so like Michael Saylor, right, like he’s just like, “Yes, T-bills are not the right answer, Bitcoin is.” Which is…it’s like a fork in the road you just went the other way. But I wonder if that has a fit or like, tell me if it doesn’t? Is that a softball question or is it something where like, you know, actually, it’s maybe not appropriate?
Nancy: No, it’s an insightful question. And I think it goes back to there’s nothing safe. Like, all investing, whether it’s T-bills or whatever you own in your portfolio, all investing involves risk. I think it’s really a question of investors making sure that their risk is diversified and having lots of things in their portfolio that could work in different scenarios. So I think the perception that any…I always like to say that treasuries are considered risk-free. They are not risk-free, there’s a lot of risk in treasuries. They’re not the safe-haven asset that people might think they are, nothing is.
And so for me, I think all investing involves risk, it’s just a question of having a very diversified portfolio so you can have a lot of different environments where that portfolio could do well. And I think inflation protection is one of those things, especially for corporates, that they are at risk. They’re at risk to higher labor costs, they’re at risk to supply chain disruptions that cause higher input costs. It’s a real risk for corporates, but I don’t think that we…maybe they don’t know about IVOL yet. But I definitely don’t think…we don’t have any corporate clients that I know of yet in our ETF. And I don’t know if corporates think about inflation a lot, but they probably should. I think it’s a good point.
Meb: We’ve started to…if you were to somehow figure out how to Google Trend this conversation and narrative, you would see it picking up. I’m one of the few that thinks in this term. We’ve had some discussions with others about it. The discussion seems to be increasing, accelerating. There are actually a few startups that are tackling something like this, albeit from a different angle. Whereas their entire, sort of, takeaway is you want a diversified portfolio not just for your investing account, but also for safe money too. And you kind of walk through the simulations of drawdown and volatility, etc.
But there’s definitely some more work to be done. Part of which is thinking about a traditional buy-and-hold portfolio for most investors is highly, highly correlated to their human capital, which seems really at odds of what you would actually want. You’d want to have more money when everything hits the fan than less. So I think you’ll see a lot more work there done by the academics at some point and practitioners like yourself. 2021 is almost over. Quadratic, you guys have been a rocket ship the first few years into the business. What does the horizon look like for you guys? Is it more ETFs? What’s the plan as we progress down this decade?
Nancy: Well, I really hope that Quadratic is thought of…I don’t know what that timeframe is 5, 10, 15 years from now as…
I want to be the Vanguard of convexity. I want to be the low-cost provider of positive convexity solutions to investors.
I think too many fixed-income investors are short convexity, and they just don’t know it, and they’re not aware of it. And so to give investors another not just to be short optionality but to be long optionality.
So that’s my big-picture goal. And to do so in such a low-cost way makes me feel really good, it makes me sleep well at night. I feel like everybody, you want to make a difference. You want to do something that’s good for people’s portfolios. And I think that’s one thing having the freedom to run my own business and think a little bit differently about risk management and about inflation even, it’s been a pleasure to be able to build this business. And I hope, just like the Barclays Agg, a third of it is mortgages. I hope a third of it one day will be IVOL.
Meb: I was laughing as you’re talking about…I don’t know if most fixed-income investors even know what convexity is. So the description of what you’re talking about, incorporating that concept, the Vanguard of it is a noble goal. And I was also laughing, I pulled up your Morningstar page, and you’re joking earlier about the longest name ever, like half of your name is shortened on the Morningstar page. But there’s an interesting…before we kind of start to wind this down, there’s one more question on the IVOL product that I think investors would like some insight on. How do you guys think about yield? Shows a nice fat yield on the website. How should investors think about this in terms of…most people think of a treasury traditional yield, 1.3%, this is what you get. How does that work with y’all’s strategy?
Nancy: SEC yield is a very specific thing, it’s interest income. So our SEC yield is actually showing almost 6% right now on our fact sheet, I think that’s a little high. That’s from the interest income from the treasuries that we own from the TIP. So that’s a little high right now, I would say I wouldn’t expect it to continue to be that high. IVOL has distributed a minimum of 30 basis points monthly since we started paying distributions in July 2019. We actually paid out 50 basis points in December 2019. And it’s a different type of spread product. Again, instead of…there are only two types of bond risk, rate risk and spread risk. We take spread risk and rates, so it’s just a little different. And that’s where we get that enhancement over government bonds for our distribution. So just different type of spread.
And I do think the SEC yield, it is accurate because it is the TIPS portion of the portfolio, but it’s likely too high and will not stay there. So TIPS are variable yield product because they reset semi-annually with CPI so it’s not always the same. But you notice a lot of TIPS ETFs don’t pay any distributions. In March 2020, the first…let’s see, I think the one that we use is the Schwab index, it’s the same passive index as TIP. And that index, really there were no distributions at all until almost the fall of 2020 because inflation was falling during a lot of the pandemic sell-off with oil and other inputs that go into CPI.
Meb: As you look back, you’ve probably made, and you can correct me, I don’t know how many, thousands, tens of thousands of trades. What’s been your most memorable investment over the years? Lived through a few different of the doozies, pandemic, financial crisis, internet bubble, what’s been most memorable?
Nancy: For me, using options is not really a trade, it’s more of a different way of investing. So I don’t really think of it as like one trade versus another trade. I just think of it as a different way of getting exposure to asset classes. Nothing really jumps out at me as like the most memorable, but I’ll think about it.
Meb: It could be happiest, it could be…I mean, what brokerage were you trading in the ’90s? Do you even remember? Were you on E-Trade faxing in your orders to Schwab, anything in particular? I have a lot of scars from option trades in my early days so it’s easy memory for me.
Nancy: I did trade a lot. On the Goldman prop desk, we didn’t use a lot of upstairs brokers because a lot of people didn’t want to trade with Goldman prop. And one kind of sweet but bittersweet memory is we used to do a lot with pre-bond and my broker, Joe Mayo, he passed away in 9/11, and he used to call me up every day and he called me sunshine. He’s like “Sunshine, what are we doing today? Sunshine, what are we doing today?” I was one of the biggest ADR option traders during that period. So we were using the foreign exchange and a lot of Scandinavian countries versus equities and it was a big correlation book. So I do think of that sometimes because it was a pretty traumatic experience. And a lot of good friends and close colleagues were lost during that event. Probably not the most pleasant thing to think of, but it is a memory.
Meb: Nancy, you guys put out a lot of great content. Where do people go they want to learn more about your fund, your strategies, your ideas what’s the best spots?
Nancy: So I’m not on Twitter but we do have a fund website, which is pretty decent, it’s ivoletf.com. And people can check out our materials and look at some previous articles and videos under the news and media. The Materials tab has all of our…the white paper for financial professionals and then factsheet in a presentation. Or if you want one of our old letters, we’d be happy to send you those by email. So feel free to reach out. There’s a Contact Us page, we want to be very accessible.
Meb: Nancy, this has been a blast. Congratulations on your success. Look forward to you hitting that three-year track record, which just opens up all the pearly gates to the big allocators and you adding some more commas. Thanks so much for joining us today.
Nancy: Thank you for having me. It’s really awesome. I enjoyed it.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.