IVOL: A First-Of-Its-Kind ETF To Hedge Against Market Volatility


  • Among the many risks facing the market is the current state of the yield curve.
  • In general, investors demand higher returns to hold longer-term fixed-income vehicles, such as U.S. Treasuries. Let's be clear, the current environment is the exception, not the norm.
  • Any one of a number of scenarios could change that, with negative consequences for both stock portfolios and real estate prices.
  • A new ETF seeks to address this, largely by offering the average investor access to tools previously available only to institutional and other sophisticated investors.

Recently, a young man asked Vanguard founder and investing legend John C. Bogle for advice on how to position his portfolio. After listing a number of specific risks - ranging from income inequality to potential nuclear war - Bogle offered the following response (emphasis mine):

You don’t know, and I don’t know, what’s going to happen in any of them, the market doesn’t know, nobody knows... so what you want to think about is how much risk you can afford.

One of those risks is the current state of the yield curve. Followers of the financial media are only too aware that of late the yield curve has flirted with inversion and, for at least brief periods, has actually been inverted. This phenomenon poses multiple opportunities for risk to a portfolio - ranging from fear of recession to a sudden acceleration of inflation.

It is exactly this risk that a recently launched ETF proposes to address. This is the Quadratic Interest Rate Volatility And Inflation Hedge ETF (NYSEARCA:IVOL). Its creator and portfolio manager is Nancy Davis, a Goldman Sachs alum who currently runs Quadratic Capital Asset Management LLC.

We'll dive into IVOL in just a little bit, but first a little background on the problem, if you will, that it is intended to address.

The Challenges of An Inverted Yield Curve

Simply put, an inverted yield curve represents a phenomenon that is out of harmony with, or runs counter to, normal expectations.

When it comes to fixed-income investments, such as bonds, investors generally demand to paid more for holding a longer-term bond, such as a 10-year Treasury, than a shorter-term bond, such as a 2-year Treasury. The logic for this is simple. First, you are tying up your money for a longer period of time. Secondly, changes in interest rates tend to affect a longer-term bond to a greater degree, making it more volatile in terms of price.

And yet, of late, something interesting has been happening. Take a look at the graphic below, from a recent Reuters article. As you do, bear in mind that this represents the relationship, not even between 2- and 10-year Treasuries, but 3-month and 10-year Treasuries.

Spread between 3-month and 10-year Treasuries

Source: Reuters article

As can be clearly seen, the graphic represents the spread between the interest rate for 3-month treasuries vs. 10-year treasuries, covering the period from 1980 to the present. You can further quickly glean that, for a large portion of that period, you would have received an interest rate between 2% and 4% greater for being willing to hold that 10-year treasury.

But not recently. As I write this, on October 28, 2019, the yield curve between 3-month (1.65%) and 10-year treasuries (1.85%) is not inverted, however it was inverted as recently as October 10. Further, as can quickly be gleaned, even today's .2% gap is small by historical norms.

What does all of this mean? As can be seen from the vertical grey bars in the above graphic, this phenomenon has often been a predictor of a recession. Why? Because it reflects what might be called cumulative investor belief, represented by the market, that inflation or returns will be lower in the future.

But back to the sentence that started this section. This is not the norm. At some point, the yield curve could start to normalize for any one of, or combination of, a number of reasons. For starters, we have the unusual circumstance of equity markets at all-time highs, the lowest unemployment rate in 50 years, and the Fed still thinking in terms of cutting interest rates!

Possible scenarios moving forward could include:

  1. A "risk off" scenario in which fears of recession trigger a sharp decline in equity markets.
  2. A "risk on" scenario where Fed rate cuts cause the economy, fueled by cheaper money, to roar back to life, triggering a round of inflation.
  3. Some combination of the above as the market gyrates while trying to figure out what is going on.

Further, given where we stand now, there could be a problematic "double whammy" for investors, as both stocks and bonds, particularly bonds with longer terms, decline at the same time.

Enter IVOL - A Hedge Against The Above Scenario

Quadratic Capital Asset Management proposes IVOL as offering a hedge should the "normalizing" of the interest rate curve - by virtue of either lower short-term rates or higher long-term rates - come to pass. How does IVOL propose to do this?

As it turns out, in a relatively simple, yet innovative and completely new, manner.

The simple part? A substantial portion of IVOL's portfolio is comprised of TIPS (Treasury Inflation-Protected Securities). In short, TIPS are Treasury bonds that are indexed to inflation, meaning that the principal value of TIPS rises along with inflation. TIPS also pay interest every 6 months, at a fixed rate established at the bond's auction but which also fluctuates based on the principal value of the bond, rising during periods of inflation and falling during periods of deflation.

The innovative part? Here it is, from IVOL's prospectus (emphasis mine):

The Fund also invests in long options tied to the shape of the U.S. interest rate swap curve. The U.S. interest rate swap curve is a type of interest rate curve that reflects the fixed interest rates used in interest rate swap agreements with different maturities (swap rates are the fixed interest rate exchanged for a floating interest rate in an interest rate swap). Such options are expected to (I) appreciate in value as the curve steepens or interest rate volatility increases and (II) decrease in value or become worthless as the curve flattens or inverts or interest rate volatility declines. The U.S. interest rate swap curve “steepens” when the spread between swap rates on longer-term debt instruments and shorter-term debt instruments widens, “flattens” when such spread narrows, and “inverts” when swap rates on longer-term debt instruments become lower than those for shorter-term debt instruments (i.e., the spread is negative).

Put simply, these are bets on options tied to the steepness of the yield curve. The innovative part? These options, which trade in the OTC fixed-income options market, have in the past typically only been available to sophisticated investors, such as institutional investors. In this ETF, Ms. Davis proposes to "democratize" this ability by making it available to all investors. Long-time ETF Monkey readers are likely familiar with my admiration for the role ETFs play in what I have referred to as the "democratization of investing."

Here's a look at IVOL's portfolio composition.

IVOL - Portfolio Composition

Source: Quadratic Capital Asset Management IVOL Web Page

As can quickly be seen, some 97.46% of the fund is held in either TIPS or cash. For the TIPS portion of the portfolio, IVOL reserves the right to invest either in individual TIPS or in ETFs which hold these. At the present time, IVOL is using the Schwab U.S. TIPS ETF (SCHP) as its vehicle of choice for this portion of the portfolio.

I found this of interest, as it is an easy exercise to dig into the composition of SCHP. Here it is:

Schwab U.S. TIPS ETF (<a href='https://seekingalpha.com/symbol/SCHP' title='Schwab Strategic Trust - Schwab U.S. TIPS ETF'>SCHP</a>) - Portfolio Composition

Source: Schwab SCHP Web Page

From the above, you are able to get a quick look at the fund's effective duration (7.7 years) and distribution yield.

So there you have it: a fund comprised 97.46% of cash and SCHP, with 2.54% currently allocated to long options tied to the shape of the U.S. interest rate curve.

Gaming Out Some Future Scenarios

In brief, here is how IVOL's founder proposes the ETF as a nice hedging tool for your portfolio in the 3 scenarios featured above:

  1. Risk Off - In this scenario, either fear of recession or actual recession lead to a sudden drop in equity markets. In this scenario, the yield curve might also steepen as the Fed is forced to cut short-term rates. This scenario would play right into the long options contained in IVOL, as these should rise in value, perhaps quite sharply.
  2. Risk On - In this scenario, recession never happens. Instead, cheap money supercharges growth and inflation rears its head. Again, in this scenario, the yield curve steepens as long-term rates begin to rise. As a side note, IVOL could prove a useful hedge for real estate (property) owners in this scenario. If rates rise, mortgages would be affected and real estate prices could fall, as the same mortgage payment would purchase less in terms of price.
  3. Confusion - In this scenario, no one quite knows what will happen next. This scenario might not be the most optimal for IVOL. However, the options IVOL holds might still benefit from possible resulting volatility and produce at least decent results.

Next, let's look at the other side of the coin. Under what scenarios might IVOL underperform? Here are two that the fund discloses:

  1. Yield Curve Remains Inverted or Further Inverts - Since IVOL's options are designed to gain based on a steepening of the yield curve, this scenario could cause the options to decline in value.
  2. Market Rally Accompanied By Flat or Declining Yield Curve - Again, in this scenario, the value of the TIPS held in IVOL decreases. Further, the value of the options either flatlines or possibly decreases.

Summary and Conclusion

Launched on May 13, 2019, IVOL is a newcomer to the ETF marketplace. As of October 28, 2019, it has a modest $72.68 million in assets. Finally, it carries a relatively steep expense ratio of .99%.

On the other hand, this ETF offers exposure to securities to which the average investor simply doesn't have access. Here's how a recent Forbes article put it:

If you want to duplicate [Ms. Davis's] 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.

Perhaps an even more important question to ponder is, what do you think about scenarios 1 and 2 featured in the article? If you find yourself of the belief that they are entirely possible, IVOL could prove a relatively inexpensive way to hedge your portfolio.

If you find yourself intrigued and would like to hear a little more from Ms. Davis herself, here's a helpful 22-minute audio and slide presentation that may be just the ticket.

Whatever you decide with respect to IVOL, until next time, I wish you happy investing!

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This article was written by

ETF Monkey profile picture
Build sustainable portfolio income with premium dividend yields up to 10%.
I am a recently-retired individual investor and have managed my own investments for over 35 years. My professional background is in the finance area. I believe that the benefits of investing, and the market, should be understandable and available to everyone, including those with little or no financial background. My hope is to explain concepts simply, taking much of the mystery and fear out of the process.  To keep up with my very latest, please subscribe to my Substack newsletter and Twitter feed. In addition to my personal writing, I am a contributing author for Hoya Capital Income Builder

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes, and to consult with their personal tax or financial advisors as to its applicability to their circumstances. Investing involves risk, including the loss of principal.

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