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The Bond Risk Investors Miss | Nancy Davis on Inflation and Building Robust Portfolios
00:39:22
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- [00:00]
Nancy Davis
The whole world right now is selling options, right? They're, they're either hedging and they want the hedges to expire worthless because it's not really, it's just a hedge or they're writing options, selling options and they just want them to expire. So we think a really unique alpha is actually using the options as part of the portfolio. When you're short options, you're short volatility. And it's not, it's not the vix, it's not equity ball, it's actually interest rate ball which is embedded in mortgages. And because of the rise of passive investing and indexing, mortgages now make up about a third of most people's bond portfolio. We did some historical research that we're happy to share with your audience on looking at other periods of after the yield curve uninverted, it can go as high as, you know, historically 300 basis points and it's at 28 right now.
- [01:02]
Jack
Hi Nancy, welcome to Excess Returns.
- [01:04]
Nancy Davis
Thanks for having me.
- [01:06]
Jack
You're very welcome. You are the founder and CIO of Quadratic Capital Management, an investment firm behind two innovative fixed income ETFs, a quadratic interest rate volatility and inflation hedged ETF IVOL and the quadratic deflation ETF ticker symbol BND. Today we wanted to have you on to not only talk about your investment process and the strategies behind these ETFs but also sort of talk about investing using options and also some macro related things where these ETFs sort of focus in on including inflation, deflation, the bond market in general, the Federal Reserve, which is top of mind for a lot of investors and just overall talk about how these strategies are constructed and I think importantly where they fit into one's investment portfolio and if someone's sort of investing in these things, how they need to need to think about them. So our audience can find out more on your work and the ETFs. You could just search the ticker symbol Ivol or BNDD wherever you get your market data or you have your brokerage account. So hopefully that's a good setup for the conversation. Nancy, we are looking forward to it. So thank you.
- [02:16]
Nancy Davis
Thank you. It's great to be here today. Yeah.
- [02:19]
Jack
You spent almost a decade at Goldman Sachs before founding Quadratic and you spent a number of years working on their proprietary trading desk managing, you know, a very large set of volatility portfolios and strategies. So I think the first thing just to get some background on you and kind of what you learned there It'd be good to learn about what you actually learned about options and trading and how that shapes the way that you think about markets today.
- [02:48]
Nancy Davis
Yeah, so the way that we run quadratic capital with all long optionality is very much something that I took from growing up at Goldman Sachs and being on the prop trading desk. So back when I started at Goldman, it was before the firm had actually IPO'd. So when we were investing partners capital, you know, the really key thing was what can you lose? And I think the whole world right now is selling options, right? They're, they're either hedging and they want the hedges to expire worthless because it's not really, it's just a hedge or they're writing options, selling options and they just want them to expire. So we think a really unique alpha is actually using the options as part of the portfolio. And it's a way of essentially think about it like a debit card. Like when you buy an option, you can never lose more than the premium that you spend. And so it's a nice way to essentially stop loss at the beginning so you know your downside and then you have that positive, you know, payout, that positive convexity when you know the theme, the trade, the macro, the expression, whatever it is, pays off. And that's really what I, you know, how I, I expressed all of our views when I was at Goldman Sachs on the prop desk and I became in 2003 the head of credit derivatives and rate trading. And I feel like right now, especially in the credit markets, it's very much like what we were looking at ED in 2001, where a lot of investors are hanging out in short duration credit thinking it's safe. And it feels very much like kind of deja vu to me.
- [04:40]
Jack
Interesting. We'll try to unpack that here in a minute because I think that that parallel could be very interesting and timely. But you mentioned, and I want to kind of just make sure we're defining some of these terms for our audience. So you mentioned this concept of convexity. Can you just sort of explain that I guess at a high level in terms of like with options and bonds and what that actually means?
- [05:03]
Nancy Davis
So it's a, it's a jargon term that people throw around and it, it's a term that really comes from the bond market. So it's a bond convexity is the sensitivity of a bond to changes in interest rates. Everyone talks about what's the duration of your portfolio. And I think the thing that we have to keep in mind is that mortgages are, you know, have negative convexity. And any type of fixed income instrument that has embedded short optionality like they call it prepayment risk. It sounds really nice and generic, but it means somebody else is long the option. You as the debt owner are short the option. And when you're short the option you have a negatively convex profile. And in the option space, convexity is kind of the same thing as gamma. It's just a different, different jargon term depending on which asset class you're. But it's like do you use a Kleenex or do you use a tissue? It's really the same thing. So in option space it means gamma which is the options sensitivity to the delta change. So how quickly your delta changes. So for instance an at the money option might have a 50 delta but then how quickly does that options delta pick up is gamma sensitivity or the convexity.
- [06:23]
Jack
What is the framework that you specifically use for identifying misprice convexity opportunities across these markets?
- [06:34]
Nancy Davis
So we focus on interest rate volatility with our two ETFs that you mentioned, the Eyeball ETF. It's not, not eyeball, but I like inflation volatility. I know it always sounds like eyeball. And then the deflation funds. So both of the funds are long interest rate volatility. And you could say like why do we care? Why should we be long interest rate volatility, why does it matter? And we created these products directly because we do not think that investors understand what prepayment risk is. What it means, it means someone else is long the option. You are short the option. Therefore when you're short options, you're short volatility. And it's not, it's not the vix, it's not equity ball, it's actually interest rate ball which is embedded in mortgages. And because of the rise of passive investing and indexing, mortgages now make up about a third of most people's bond portfolio. So for instance, the AG index is used to be the Lehman ag, then became the Barclays ag. Now it's a Bloomberg ag. But the AG has considered, you know, core fixed income. It has a 27% allocation to U.S. mortgages. And just close your eyes for a second. You know, homeowners are along the option to prepay. If you own a mortgage, you are short options to homeowners. And so that's kind of the thing. We don't think that bond investors should only be short optionality in their bond portfolio. And that's why we're Doing these products to give people a way of not, you know, if you're just a passive investor, you're probably only short ball in your bond portfolio. We just think, look, put it out there, give people choices, give them access to this market. So it's definitely altruistic and feel good thing to be really innovating and trying to better better people's outcomes.
- [08:37]
Jack
Does this, is this what's really is this point that you're taught is this what is the parallel to the 2001, 2002 period that you're seeing? Is that similar? Am I drawing that right?
- [08:50]
Nancy Davis
That was. That's a separate thing that. Okay, so that's more with the credit kind of credit curves and volume curves. So that's kind of a different topic. But this is more about just like at the end of the day, if you think about, you know, the Ag Index is what most 401ks, most pension funds. Like my mom, she's a retired teacher, she has, you know, a lot of bonds. She doesn't realize that her bonds have short optionality inside of it. And it's mortgages are reset based on, you know, consumers irrational and people prepay when interest rates go lower and you get, you know, essentially longer duration. Right. When you don't want to be. That's kind of. If you read Silicon Valley's 10Q, they mismodel prepayment risk and they got longer duration. Right. At the wrong time. And that's because mortgages are, you know, generally negatively convex. And so what we do at quadratic everything is positively convex, meaning we are, it's treasury obligations. So per our prospectus, 80% of both of our funds are Treasuries or cash. And then we have positively convex options coupled with bonds which are Treasuries.
- [10:11]
Podcast Host
It's interesting. One of the things I've learned during the podcast is it seems like a lot of us are short volatility across like all aspects of our lives in many ways. Equities, bonds. I mean, it seems like you don't realize that all of us, a lot of the things we just do day to day are sort of a short volatility bet to some degree.
- [10:26]
Nancy Davis
Yeah. And then I think the correlation is so important too because if you have, you know, if you have a portfolio with a bunch of stocks and then you have a portfolio with a bunch of bonds, but all those bonds take corporate credit risks. You kind of have like the same beta. Right. You might have a different part of the capital structure, but if you own one company stock and the Same company's bonds, you're kind of exposed to the same stuff. So, so it's so important just to a think about, you know, everybody is really kind of naturally short volatility because of this index construction stuff and the move to passive, just not saying it's bad, it's just, it's what it is. You have to understand what it's doing. But then yeah, everybody is kind of short volatility in our, in our real life. And then I think at the end of the day, short inflation, right? Like that brings me to my other like, you know, pillar I love to stand on is I personally think everyone should own the eyeball etf. You know, that's a broad statement that's pretty bold. I'll explain why. But you know, we, we live in a real world and everybody, no matter what industry you're in, you know, what age you are, especially as you get closer to retirement, you have like a limited amount of savings and your goal is to be able to retire and live off the income from your savings and have the same lifestyle. And people's big risk is inflation. And everybody I feel like right now is trying to speculate whether I feel like inflation. People think of it as a trade. They're trying to think is inflation going higher or lower. I'm like, it doesn't, it doesn't matter what you think because you, you know, we all live in a real world, right? We all have real expenses, real costs, you know, a limited amount of savings. And I think we as you know, real people are actually short inflation in our real life. So that's why it's so important to have, I think especially given that the Fed's just starting a rate cutting cycle. Assets are at arguably all time highs, credit spreads are at all time tights and inflation expectations are low. You know, people do not think it's going to be a problem. And that's, I want to kind of grab people and be like, look, this is a really important time in your life to say what can you do to, you know, not everything's going to make money at the same time, right. It's not a, it's not a total return strategy. You know, all investing involves risks. But I think it's so critical that people understand the AG index has, you know, 0, 0 inflation protected bonds in the AG. So no, you know, how can you be core fixed income without any inflation and only be short optionality.
- [13:13]
Podcast Host
Yes. I want to ask you about this idea of managing inflation risk because what you're talking about is A little bit of a different approach than many people take. I mean many people will own the gold or their own commodities or they might own some real estate or they might own tips. And you're doing that in part, but you're doing some other things on top of that. Can you just talk about how someone would think about this, this method of managing inflation risk versus maybe those conventional methods?
- [13:33]
Nancy Davis
Yeah, it's so, I'm so happy you asked that question because it's like there's such group think around inflation. Like the, the facts are the US treasury only started issuing inflation protected bonds in the late 90s. Right? In the late 90s is when the inflation protected bond market started. And the only index to reset inflation protected bonds or inflation swaps or breakevens or CPI swaps is one index. It's one single index called the consumer price index. Right? Like I want to grab people and be like, you would never buy one index in your equity portfolio and say, ta da, I'm done. I got the stock market. You know, it's crazy that people are using this one index to calculate inflation. Especially after hearing from the Fed for years that they don't even use the cpi. Like why would we use the cpi? And you know, talk about, everybody's talking about Fed independence. Like what about the Bureau of Labor Statistics? They're the ones who calculate the cpi. And by definition a third of that index is what they call rent. It's owner occupied rent in the form of shelter. So it's just not the only way to think about inflation. And then going back, don't get me started on my, you know, standing on my soapbox. But everybody looks at what happened in the 70s, right? Like I want to grab people and be like, the inflation markets did not exist back then. There was no inflation market, there was no interest rate market, there was no interest rate derivatives market. There was even no tips. It started in the late 90s. So looking at the 70s especially like things like oil, you know, I would, you know, close my eyes like, yes, gold has been going up. I'm not, I'm not saying anything bad about gold. I don't want hate in this, you know, podcast. I'm just saying gold is a great psychology trade. It's a great dollar debasement, currency debasement psychology, a lot of other things. But it's not necessarily a great inflation trade because it doesn't pay a coupon, right? So right now when you can get, you know, overnight risk free money from, you know, the Fed at, you know, Fed hasn't cut rates yet to zero. You're paying, you know, you're not getting that 4% right now to own gold. And yes, it's been a great performing asset class, but I don't think dries would you want to own oil for the next like, you know, 40 years to capture inflation, like agriculture, perfect example. People would be like, oh, I want to own food prices. It's a deflationary thing because of technology. Right. Fertilizers, you know, hydroponics. There are so many things that have made ags not a great inflation hedge because of technology. And I feel like oil is that same thing. Whether it's fracking or looking at, you know, solar, other sources of energy, it's just like, it just drives me crazy because people look at the 70s and they do all their back testing and I'm like, you're missing the whole obvious market, which is the inflation markets, which are newer and tips are not a great product on their own. And that's why we created Eyeball. We take tips and we try to fix the issues inside of tips with the options. Yeah.
- [17:04]
Podcast Host
And to your point about gold, I mean, if you look historically, this is something I've researched a lot more recently. Like gold is not the greatest inflation hedge. I mean, sometimes it's an inflation hedge, then sometimes it's not an inflation hedge. So if you're looking for something that's a consistent inflation hedge, and like you said, it's hard to badmouth gold right now because it's on fire, but it hasn't been that consistent throughout history. Yeah, but do you, have you found that too, that it's not, it's not that consistent throughout history in terms of being an inflation hedge?
- [17:25]
Nancy Davis
Yeah, we actually wrote a, a white paper on it, so if anyone wants it, we'd be happy to send it. And it's not, it's not saying gold's a bad investment, not saying you shouldn't own it. It's just saying if you own it for inflation, you might want to think about other things that you can also use to capture inflation.
- [17:45]
Podcast Host
Since we've been talking about inflation, I want to ask you about inflation because. And your take on it overall, because we're sitting, you know, I guess around 3% with inflation right now. We're not, I mean, we're not spiking a lot, but we're also not going back to the Fed's target. I'm just wondering what your take is overall or if you have one on where we are with inflation right now.
- [18:02]
Nancy Davis
You know, Real yields have not been this high in a very long time. The break even rate, which looks at where implied CPI is expected to be. So right now the 5 year break even is 2.32, the 10 year break even 2.27. So I'd say the markets are priced to be right around that 2% inflation long term target. And to me I think that's a buying opportunity because there's no 2% is just a made up number, right? It's, it's not, not a, like why 2%, why is that a real number? But that's where inflation markets are saying CPI is going to be. And then I think a really simple way of getting inflation expectations outside of CPI is using the yield curve. And that's what we do inside of the Ivol ETF is we essentially own call options. They're not called call options, it's a different jargon term, but it's basically to express a steeper yield curve, which to me is a really nice other index to measure inflation expectations because that's where the rest of the world lends money in dollars, right? The, the Fed sets the policy rate, they set the overnight rate, but the rest of the world dictates the cost of owning, you know, US dollar denominated duration. And the yield curve right now is very, very flat. We own, you know, there's a lot of different yield curves depending on which rates you're looking at. A lot of people focus just on the treasury curve. But what we look at is the, the difference between two swap rates. So we use the SOFR rates and right now that rate is the twos 10. So for spot curve is 28 basis points, you know, 2, 8. So it's very, very cheap from a historical average. And we're coming out of a period of extreme long and low yield curve inversions. So in 22 the Fed, you know, remember they, they went from, we're not even thinking about, thinking about raising rates to the fastest hiking cycle, even more so than Volcker. And that caused the yield curve to invert and stay inverted for three years. It's just now starting to come out of inversion and it's again the 210 spot SOFR curve at 28 basis points. Like on average when that yield curve starts to go, you know, through the, the uninverted to positively slope line, it doesn't, it doesn't, you know, it goes up quite a bit. We did some historical research that we're happy to share with with your audience on looking at, you know, other periods of after the yield curve uninverted, it can go as high as, you know, historically 300 basis points and it's at 28 right now, under 30. So it's, you know, on average it's around 100 basis points, which makes sense. For instance, Jack, if, if Justin was to say, hey, could I borrow $10,000 from you? Right? And he said, you know, I'll pay you back in a year. And you said, okay, I'll give you, you know, whatever his credit risk is. And you say, okay, I'll give you a loan for what would be your interest rate. Just curious if he wanted to buy.
- [21:23]
Podcast Host
10,000 bucks just, just as a dicey credit risk too. So I got to, I got to take that into account.
- [21:28]
Nancy Davis
Okay, so like whatever, whatever your spread is, then turn around. And he says, he says, actually instead of one year, can you loan me that money for 10 years? You know, would you charge him more or less than your one year rate?
- [21:45]
Podcast Host
You're going to demand a significantly higher rate for that.
- [21:48]
Nancy Davis
Yeah. And that's, the market is not pricing that right now. And that's what's so crazy is the US has one of the lowest level of yield curves in the whole world. Like other markets, Even, even Japan's 2, 10 yield curve is, is steeper than ours right now. So it's, it's really exciting time because eyeball, I think is just the yield curve just uninverted in 2025 and it's just starting to kind of normalize. And on average, if you look at the, the swaps, 2 cent swaps curve, it's typically around 100 basis points. So it's, it's exciting because there are not many things out there in the financial markets that are trading at, you know, kind of low valuations. Right. There's not much stuff out there that you're like, oh, that's not at historical highs. And this is one of those things. And it's also inflation expectations outside of just the consumer price index.
- [22:44]
Podcast Host
So do you, do you have views on inflation personally? Like, do, do you think inflation might be like the risks might be to the upside with it, or is these not really necessary for what you do?
- [22:53]
Nancy Davis
Yeah, I, I personally think people should have some allocation to inflation in their portfolio. Like I just think, you know, everybody at the end of the day needs to. And it's kind of an orphan asset class in the United States because the AG index has no inflation protected bonds. So it creates tracking risk in these portfolios. So most people don't have inflation protected assets on their Own, you know, because it's not in the indices. So to me, I think it's just like a important part of a diversified portfolio is like, what if, like, you know, just close your eyes for a second, right? The Fed is probably going to be cutting rates, probably cutting rates pretty aggressively. You know, it's. Should they do that? Is that, you know, can you put the inflation genie back in the bottle? And inflation expectations, you know, are not expensively priced, they're not at historical highs. And interest rate volatility, don't even get me started on that, that is, that to me is like a backup the truck. Really, really attractive, you know, very, very low historical levels. And you know, you might be surprised to hear that interest rate volatility, if you look at like Silicon Valley bank, which was not that long ago, that was 2023, interest rate volume is down about 40% since Silicon Valley bank. And like literally nothing has changed. If anything, it's gotten worse. All the, all the issues that are out there, you know, it's, it's just, it's a very attractive time. Meaning the price of convexity, positive convexity, the price of that asymmetric payoff given the price of implied volatility is very low. It means you can buy for the same, you know, dollar premium you spend. You can buy a lot more options for that with the cost of implied volume. Because implied volume, like whenever you talk about options markets, if you buy an option, you're always long volatility. If you sell an option, you're always short volatility. And the price of volatility dictates how expensive that option is to buy or sell. And so right now, interest rate volatility is very, very low, in my opinion. It's kind of a, you know, our type of interest rate volume is trading around 3 basis points a day, which, you know, think about how much, you know, just on nothing, you know, markets can really move. And so I think it's a really unique opportunity.
- [25:23]
Podcast Host
Yeah, I didn't realize actually the move had come down that much because I remember like back in 2022, everybody was talking about the move was going crazy and the VIX was not responding. And a lot of people were talking about that divergence and whether it meant anything.
- [25:33]
Nancy Davis
Yeah, and the move is just one index that looks at, you know, 30 day options. So what we own in Ivol is a lot longer dated options. And the, the ball curve is what you call backward dated, meaning it's downward sloping. So the cost of owning longer dated options is even cheaper than the shorter dated options. So like, it's. So it's a pretty cool thing to have a backward aided volume curve because, like, think about it, most of the time, you know, the future is more unknown than the present. So typically you would have a volume curve be upward sloping, meaning the cost of volatility is higher in the future, not lower. And so that's a really unique thing about the, our type of market that we access inside of the eyeball etf.
- [26:23]
Podcast Host
I'm just curious, as an aside, if you looked at anything about the relationship between bond volatility and stock volatility, does it mean, because people were talking about that all the time in 2022, the bond volatility went crazy and stock volatility should follow? Like, is there any relationship between them at all?
- [26:36]
Nancy Davis
I mean, generally correlations can go up at any point. Right? And I think that's the, the big risk to all portfolios is kind of, especially a 6040 portfolio would be the stagflation risk, which is when, you know, stocks and bonds, there's no guarantee that they're negatively correlated. In fact, they could be positively correlated. So I think that's just one thing that, you know, you always have to be thinking about. It's not just volatility. And I think again, most people are always focused on equity ball. And I want to grab people and be like, that doesn't really. It's not, you're not naturally short equity volume, but you're naturally short fixed income ball because of the allocations to mortgages and prepayment risk inside of a lot of these, you know, structured credit, like the search for yield has pushed people into a lot of instruments that take credit spread risk. And a lot of these credit products have prepayment risk, which means somebody else is long the option, not you. And when you're short options, you're short that, that negative convexity, that short optionality, that short volatility.
- [27:45]
Podcast Host
And to your point, in, in 2022, long equity volume didn't help you that much, but long bond volatility did help you. And so I guess with these inflation surprises that that might be a better protection.
- [27:56]
Nancy Davis
It's just something different. Like, I think, I hate the word protection because I'm like, all investing involves risk and there's nothing, no free lunch. Right? But I think that's a point. The goal for investors is just to have a diversified portfolio and to understand and not have things be too correlated with each other. And so I think our funds are not nothing to do with equities. They're not long equity volume, they're long interest rate volume. They're, you know, 80% of the fund is Treasuries and cash. So it's not taking, you know, credit spread risk. Like, you know, some of the other products out there, like Clos, take credit spread risk, right, with lending money to corporates and loans. So it's just something else which I think is, you know, is good because a lot of people have, you know, a lot of correlation between their stock and bond portfolios. Right now.
- [28:49]
Podcast Host
How would someone think about, like we're not going to give it, we don't give advice here obviously, but if someone thinks about this, like in a portfolio context, how they would use something like this, how would you think about that?
- [28:59]
Nancy Davis
So again, I'm not a financial advisor and I don't, you know, not my area of expertise, but I can tell you from talking to our clients, a lot of our clients use it as a compliment to the AG index. So they'll say, all right, we have our whatever, 60, 40, whatever it looks like, plus or minus a little bit. And they say what we allocate to the ag, we know that the ag, a third of it approximately is mortgages. So they'll allocate about a third of their bond portfolio into Ivol, depending on how much they want to reduce that embedded short volatility exposure and also to add inflation protected bonds because there's no tips inside the aggression and it's only short volume. So most people just use it as a compliment to what they already have to make it. You know, I think about people, people have the AG because it says core fixed income. But how can you be core fixed income if you don't have any inflation protection, especially in this environment and you're only short optionality.
- [30:02]
Podcast Host
It's just an aside, but I'm curious because you obviously have a detailed knowledge of what's going on behind the scenes in the bond market and we've talked a lot about the national debt on the podcast and I'm just wondering, do you have any views on that, like in terms of its impact on the bond market long term?
- [30:14]
Nancy Davis
I mean, look, people have been screaming about the debt and I remember seeing that counter in New York City about it. I remember that it's, you know, the world is, is awash in debt and I think it's a, I wouldn't say it's a, it's not going away anytime soon. I do think, you know, the, I do think interest rate volume is a pretty good and attractive asset. Class to own because we don't really know what's going to happen. And I think when you, you know, when you can buy something that is a downward sloping volume curve that is trading at relatively historically low levels that you kind of naturally have short anyway I think is a really nice just diversifier.
- [30:59]
Podcast Host
Can you talk about the other fund, bnd, we've talked a lot about. Ivol, what, what is your thought process in terms of how you construct that?
- [31:05]
Nancy Davis
So that is nominal treasuries, meaning not inflation protected treasuries. So we use really long dated nominal nominal Treasuries inside that fund. And that's for people who think the Fed is not going to cut rates at all and that 30 year yields are going to go lower, meaning bond prices higher. That's the fund for you. It's a way, I'd say it's like it's more like espresso to coffee. So it's you know, super long duration nominal Treasuries plus the kicker of you know, either the Fed not cutting or 30 year yields moving lower bond prices higher. So it's like a turbocharged, it's like espresso beans.
- [31:52]
Podcast Host
And are they, are they mutually exclusive? Do you typically see people using one or the other or is there, is there a case that both would be, would work like inside of a portfolio?
- [32:01]
Nancy Davis
Yeah, most people have Treasuries and then they also have inflation protected Treasuries. So it's not like a one or the other people, people don't pick a side. You know, most people have nominal Treasuries and no inflation protected Treasuries. So I'd say, you know, that's why I'm kind of push eyeball more because most people naturally have some allocation to regular Treasuries but they don't have an allocation to inflation protected Treasuries. And that's just because in the United States inflation protected bonds, it's kind of an orphan asset class. It just doesn't exist. Whereas in other countries like the UK for instance, their pension funds have what they call linkers in their benchmark. So they have to by mandate own inflation protected bonds. Here that's not the case. You know, people just don't care. And that's why I think it's kind of such a thing that I want to stand on my soapbox and be like when, when everybody's like ignoring an asset class and it's really cheaply priced. Meaning like, you know, we don't know whether the Fed cutting rates or not cutting Rates or whatever is going to happen. To me, that's like something that you want to own.
- [33:14]
Podcast Host
So it's interesting to your point. Like as a financial advisor, I see a lot of people's portfolios when they come in and I almost never see tips.
- [33:21]
Nancy Davis
Yeah.
- [33:22]
Podcast Host
In a portfolio. So they are, they're widely underused, you know, relative to their value, I think.
- [33:27]
Nancy Davis
And TIPS are not great on their own because all TIPS use is a consumer price index. And so it's not saying it's a, it just needs tweaks. And, and TIPS are naturally all long duration. So it's like, if you want to own inflation protected bonds, why would you want to own duration? And so a lot of people's solution to that is, okay, we'll buy short dated tips. Well, break evens. Like if you pull up the one or two year break even in 2008, there's no zero bound. Like it can go massively negative. The, the one year, two year break even, it went down to negative six. So there's no zero in the interest rate and inflation markets. And short dated tips don't have the duration. But you're also making more of a realized bet on the Bureau of Labor Statistics. Right. It's like, where do they calculate that CPI number? Like, I don't, I don't want that. You know, I'd much rather have a longer dated tip. But to have a way to actually profit from when duration sells off, instead of hedging it, we can actually do well when duration sells off. Like if you look at the first quarter of 2021, I've always, I'm doing this off the top of my head, so this might not be right, but 311 basis points, when tips alone, and we had about 85% in tips were down, you know, about 150 basis points. So because of that, that positive convexity when the duration sells off, here's a way, instead of hedging your duration, here's a way to actually profit from rising inflation expectations, especially when the Fed's gonna be cutting rates whether inflation's a problem or not. Right, I'll leave it there.
- [35:14]
Jack
But I think what's great about this is, you know, this, you, you, you've brought these strategies into a transparent ETF wrapper, cost effective. And you know, I know with Ivol, at least it's, you know, north of 400 million in assets. So clearly the, you know, the market is, is starting to pay attention to this and you know, you're growing nicely and I think conversations like this can Help investors understand where something like this fits inside a portfolio. So this has been great. Nancy, we have two standard closing questions we like to ask all of our guests so you can go anywhere you want with it. But the first one is what is one thing you believe about investing that most of your peers would disagree with you on?
- [36:01]
Nancy Davis
So I think most of the world are option sellers. And I think I'm like, I'm this weird, you know, kind of magic rainbow unicorn in the world of investing because like 99% of people, all they want to do is sell options. And to me, you know, they all have it wrong because people take their portfolio, their core, like linear delta portfolios. So stocks, bonds, things that go up a dollar, down a dollar and then the options are around the periphery. For me, the options are the investments, they are the portfolio. So I would say that's like totally opposite, opposite day compared to the way, and to Jack's point, I think most people are short volatility and they just don't, they just don't know it. You know, it's like hidden inside these key steps.
- [36:52]
Jack
And the last question, just real quick is based on your experience in the markets, what's the one lesson you would teach your average investor?
- [36:58]
Nancy Davis
Oh gosh, selling, selling options is not income. It's selling options. It's not sec yield, it's not income. In my opinion. It's just I, I want to grab people and be like, look, you're taking something like, like there are a lot of strategies and I'm not saying it's a bad strategy. I just don't think it's income. I think it's just selling options, right? So that's the one thing I think people don't really understand. And, and you, you talk to people who are trading like zero day options and they're, they call it, they're like, oh, we write options all the time. You know, that can be, that can be dangerous. Cuz especially you sell an option, you know, the most you can make is a little bit, the most you make is that trade, right? You just want it to expire worthless. And I don't think people really understand that you can have, you can lose a lot more than your, than you're collecting. You can lose, it's super negative convexity. So I, I just want to be, I feel like the world has gone a little crazy with the use of, you know, derivatives have a really bad reputation for a good reason, you know, So I think when you buy an option, you can lose it all. Like I'm not saying you can't lose money, but you can only lose what you spend, right? It's kind of like a debit card. When you sell an option, you collect a little bit and you can lose a lot more. Even like people say, oh, it's covered. Well, you know, you, you are selling away the upside in that equity or that stock or whatever you have. And there can be tax implications from that as well. So there's no free lunch. That's what I'd say. All investing, all of it, involves risk.
- [38:44]
Jack
Thank you very much, Nancy. We've enjoyed the conversation and we wish you the best with the ETFs, and we look forward to following your success.
- [38:52]
Nancy Davis
Thank you. Thanks for having me on as your guest. I really appreciate it.
- [38:55]
Jack
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excessreturnspodmail.com no information on this podcast.
- [39:16]
Podcast Host
Should be construed and as investment advice.
- [39:18]
Nancy Davis
Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.