Wealth Advisor Managing Editor Scott Martin sat down with Nancy Davis, Managing Partner and Chief Investment Officer of Quadratic Capital Management and the brains behind the firm's Interest Rate Volatility and Inflation Hedge ETF (ticker: IVOL), a unique investment vehicle designed to address some of the shortcomings in traditional inflation-protected bonds and provide access to inflation markets beyond the Consumer Price Index (CPI).
Inflation protection has long been a concern for investors, especially when it comes to the limitations of traditional solutions such as inflation-protected bonds. As Davis explained, the duration of these bonds tends to be long, which can pose challenges for investors. At the same time, the reliance on the Consumer Price Index as the sole measure of inflation is constraining, considering especially that even the Federal Reserve uses other indexes and survey data.
Treasury inflation-protected securities, or TIPS, are known for their long-duration nature, making them less suitable for investors looking for shorter-term protection against inflation, Davis noted. IVOL ETF, on the other hand, offers more flexibility by using long interest rate options, a type of derivative that enables shorter-duration hedges. This approach limits potential losses to the premium at risk, ensuring a fully funded option.
In addition, IVOL ETF goes beyond the CPI, opening up access to interest rate markets that were previously inaccessible. By incorporating long interest rate options, Davis explained, Quadratic’s fixed-income ETF provides investors with exposure to a more comprehensive range of inflation expectations, which can be critical for managing portfolio risk effectively.
One significant advantage of IVOL ETF Davis highlighted is its accessibility. Unlike the traditional inflation-protected bond market, IVOL ETF leverages the use of CUSIPs for rate futures markets, allowing investors to trade these instruments within an ETF wrapper. This accessibility makes it easier for advisors to incorporate IVOL ETF into their clients’ portfolios.
Davis clarified that IVOL ETF does not rely on futures but instead uses long interest rate options. This distinction is essential because it offers a different risk profile. It’s a type of derivative, but it’s fully funded, meaning investors can never lose more than the premium they put in.
One of the interesting aspects of IVOL ETF is its potential to protect homeowners. Davis explained that if an advisor or broker-dealer has clients who are homeowners with mortgages in their portfolios, they are effectively short options to homeowners. In the United States, homeowners have the option to prepay their mortgages without penalty, which creates exposure to short volatility.
IVOL ETF provides a way for advisors to address this risk by allowing them to own fixed-income volatility and hedge against the short volatility exposure that comes with mortgages. Davis noted that although there are no guarantees in investing, IVOL ETF offers a means to add inflation and inflation expectations outside of the CPI, providing a valuable tool for managing risk.
