We Study Billionaires - The Investor’s Podcast Network - TIP473: Using Volatility to Hedge Against Inflation W/ Nancy Davis

Starting point is 00:00:00 You're listening to TIP. My guest today is Nancy Davis. Nancy is the founder of Quadratic Capital Management and manages the portfolio for both the inflation hedge ETF, ticker IVOL, and the Quadratic Deflation ETF, ticker BNDD. Before founding Quadratic, Nancy spent 10 years at Goldman Sachs where she became the head of credit derivatives and OTC trading. Barron's has named her one of the 100 most influential women in finance and you've likely seen her as a frequent guest on CNBC, Bloomberg, and others.

Starting point is 00:00:33 In this episode, you will learn Nancy's predictions on the forward guidance from the most recent Fed meeting in Jackson Hole, which was kicking off right at the time of this recording, what Nancy is watching to determine if inflation has peaked, which indicators Nancy pays most attention to, how to use the volatility markets to hedge against inflation, the basics of bond convexity, opportunities for when inflation and interest rates move towards parity and much, much more. I really enjoyed having Nancy on. I certainly learned a lot about the mysterious world of volatility markets, and I think you'll find some really interesting strategies here. So, without further ado, please enjoy this conversation with Nancy Davis.

Starting point is 00:01:12 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast. I am your host, Trey Lockerby, and today we have our new friend Nancy Davis on the show. Welcome to the show, Nancy. Thanks for having me, Trey. Well, I've been loving all your commentary. I see you often on CNBC and Bloomberg, other media outlets, and I've always really liked your opinions and your perspective. And the news of the day today, we're recording this on August 25th, but today the Fed is meeting in Jackson Hole as we speak. For those who don't know, the Federal Reserve Bank of Kansas City's annual economic policy symposium, which is held at Jackson Hole, is kicking off this weekend.

Starting point is 00:02:11 It's a three-day gathering. And it includes a lot of central banks around the world. And most notably, Jerome Powell will be speaking. And we're going to hear hopefully some interesting thoughts from him and probably a narrative change from some other thoughts he's said in the past. For example, about a year ago, he said inflation. It was transitory, quote, unquote, which I think does not pan out quite as he had hoped. The Fed hikes are getting up to 150 basis points this year and the markets, you know,

Starting point is 00:02:36 despite some decent corrections, have actually absorbed the hikes, I think, fairly well. But what's your personal opinion on where the forward guidance goes from here? I think the Fed has a lot of upside at this Jackson Hall because it probably couldn't go worse than their predictions at the last Jackson Hall. They said the labor market slack was going to be easing. They said inflation was transitory. I think we'll see what they say. But I would expect they would really be addressing the inflation that everyone is feeling in their day-to-day life. It's been very hard for a lot of people around the world.

Starting point is 00:03:11 It's a global thing right now. A cost of food is expensive. It's really hurting small businesses. The labor market is still incredibly tight. And so I think I'm curious to hear if the Fed is going to address more using their balance sheet as a monetary policy tool. I feel like right now they keep hitting only one nail over and over and over again, which is hiking rate.

Starting point is 00:03:35 and hiking policy rates can help on easing demand, but it doesn't help on other aspects of the supply side issues or the labor market. So I'm really eager to hear if they talk more about using their balance sheet as a way of reducing inflation expectations. Because I'm relieved that we had CPI, the last print was 8.5, which was down from 9.1, but 8.5 is still nothing to get excited about. And I think the big problem with that CPI number is it's just one index, right? It's a consumer price index. Just like you wouldn't look at the Dow Jones index and say, aha, this is equities or the U.S. stock market. You can't do that with inflation either because so many people, it's so personal, right? What impacts everybody's day-to-day inflation expectations?

Starting point is 00:04:24 But I'm sure they're going to be very tough talking about inflation because the last time they said it was transitory. and they were so wrong. Your former employer, some economists over there, Goldman Sachs, have come out thinking that instead of these 75-point basis hikes they've been doing, it probably would be more like 50, just given that inflation is sort of, I mean, to your point, it's how do you measure it? But it's been relatively flat month over month, or at least, you know, from June to July. Do you have any expectation of your own as to what a further rate hike might look like? The rates market has already priced in additional heights. And there's more than 75 that's priced in just before the end of 2022. So the Fed needs to hike 110 basis points just to meet what's priced into the market. So I don't think it really matters whether it's 75 and then a 25 or whether it's a 50 and 225s. The reality is what's priced in is already there. And you can see that.

Starting point is 00:05:27 with the level of the two-year interest rate. It's so much higher than where the Fed Funds policy rate is, which is a band is $225 to $250, but you can buy even a T bill and a short-term Treasury bill and get paid over 3%. So the rates market has already priced in that expectations of hikes. And so it's really up to the Fed to either meet those expectations or say we're going to be doing something else

Starting point is 00:05:55 other than hiking policy rates to combat inflation. I like that you focus on that. I've heard you say that it's not what the Fed does. It's what is priced in. So let's talk a little bit about inflation because I'm curious if you think it's actually peaked. The CPI was unchanged, seasonally adjusted. It rose 8.5% over the last 12 months.

Starting point is 00:06:16 And the index, I love this fact about the index with less, you know, if the food and energy is only a 0.3% seasonally adjusted, which who doesn't use food and energy, but anyways, in your opinion, are we seeing the rate hikes actually ease inflation, or is it too early to tell? I think it's probably too early to tell because I think the one thing, I feel like everybody right now is speculating on whether inflation is going to be falling or going up or going down. I feel like everyone right now appears to be a macro tourist, right?

Starting point is 00:06:50 And everyone has their own view about what's going to happen in the future. I think people are really not thinking about it the right way. In my opinion, you know, if you just think about your personal balance sheet, right? You have your whatever you do professionally for your job, you have your savings. And if you don't have inflation inside your portfolio, you're actually short it in your real life because we do live in a real world and hire, you know, we do have to consume things. It doesn't, not everybody consumes the CPI, they're different, whether it's, you know, college tuition or, you know, avocados or, you know, diesel fuel, whatever it is. We do live in a real world. So I think everybody has exposure to inflation in their real life. And I think it's foolish to try to bet

Starting point is 00:07:41 whether inflation's going to be going higher or lower. It's not a trade, right? It's your life and it's your savings. And I think I think it was Ronald Reagan who called inflation. the thief in the night. And I think that's really important, especially for people who are retired, right? It's even more critical for those people because they're not going to benefit, if you go think about a personal balance sheet,

Starting point is 00:08:04 they're not going to benefit from wage inflation, right? Because they're out of the labor market. So they're just going to have a higher cost of living and that pool of savings with whatever investments are inside of it are going to have to, you don't want to outlive your wealth, right? and inflation is one way, especially if you have fixed income and interest rates are moving higher, you can look at some government bond funds have lost way more in price terms than U.S. equities. And that's especially hard for retirees because they think they're being more safe by having

Starting point is 00:08:38 less equity exposure, but they've actually lost more than if they did have more risky portfolio. So it's just, I think people are overthinking about whether it's going to continue or not. I don't think it really matters. And I do think it's a really important thing to stress that future inflation expectations are really not very high right now. Even though realized inflation is at 40-year highs, whether you say it's nine or eight and a half or eight, even seven, it's still high. But future inflation expectations are priced very low. And that's because the market thinks the Fed hiking policy rates is going to ease inflation in the future. So just like when you're evaluating buying stocks, it's not about what did the company do last time.

Starting point is 00:09:25 It's what is a multiple, what is the earnings estimate? Do they beat earnings? Do they miss earnings? Right now, future inflation expectations are very cheap. They're very much around the 2% symmetric target of the Fed, even though realize inflation is so high. On that point, what if inflation has actually peaked? And what do you think about this sort of, I would say, disconnect between what the markets are saying and the actual economy, because there's some alarming data points in the headlines like Redfin reporting mortgage rates nearly doubling from last year. USA Today reported more than 20 million U.S. households are behind on their utility bills, retailer inventory glove from Walmart and others.

Starting point is 00:10:07 I mean, there's this ominous sentiment out there with the actual economy. Do you think there's further to fall or is consensus just playing into its typical fear? your full bias. I think there are a lot of risks out there. I mean, inflation is raging. We have a lot of, you know, whether it's droughts or geopolitical tensions or consumer sentiment being at all time low. I think the problem is also the labor market is that it's really hard to hire people. Like they're, you know, even though people have added more, more employees or productivity is down. So it's a really tough time for small businesses in particular. And I think people really should be adding in, you know, things that are more defensive to their portfolio, in my opinion, because we just

Starting point is 00:10:54 don't know what the future holds. We don't know if the Fed hiking policy rates is going to do anything to stop inflation. And right now, the rates markets are priced that future inflation is going to slow dramatically. You mentioned earlier the Fed's balance sheet, and I've actually heard you refer to it as the elephant in the room. Even the market has been absorbing these rate hikes, do you think the Fed will get more aggressive with offloading its balance sheet? And if they were to do that, what exactly would be the steps you think they would take? Well, the Fed has been very delicate so far. They put in place these caps. That's probably because the last time they tried to do balance sheet unwind, they totally blew up the market. So they're being very delicate with their

Starting point is 00:11:36 steps this time. The Fed's caps are going to increase in September. So I think it'll be really interesting tomorrow with Jackson Hall in the press conference to see if the Fed talks more about maybe not holding mortgages on their balance sheet. They've alluded to that in the past. It's really important that investors look inside their fixed income portfolio, especially things that are core fixed income because so much of the market has moved into indexing, Right. And there's nothing wrong with indexing. But when you have a lot of these core fixed income managers, it tends to be that a third of their exposure is mortgages. And mortgages, very simply, if you think about it, homeowners are long the option to prepay. So owners of financial mortgages are short options to homeowners. And whenever you're short options, your short volatility. So most people, I don't think really realize it, but within their fixed income portfolio, they tend to be short fixed income volatility. So it's super important to see if you have

Starting point is 00:12:45 things called a core fixed income, they tend to be benchmarked to the ag index. And the ag index is just, it's old, right? It used to be the Lehman Ag and then it was the Barclays Ag, and now it's called the Bloomberg Ag, but it was created before the U.S. Treasury invented the inflation protected market. So it has no inflation protected bonds in the ag, which is not very core to me if you have no inflation protection. And it tends to only have short volatility because about a third of the ag is mortgages. So I think it's just super important to be mindful of what you own and don't go by the strategy's name, really see what's inside your portfolio and where your risks are. You know, Jim Kramer came out today saying he thinks the market's going to be flat after this

Starting point is 00:13:32 weekend. In my opinion, that's kind of shorting the volatility, if you will, like you were just kind of saying, which anything he says, it gives me a little bit of pause. But I'm kind of curious, when you talk about owning options or shorting options being shorting volatility, can you talk a little bit more about that and what you mean by it? Yeah. So, anytime you sell an option, you're actually selling volatility. Whenever you buy an option, you're buying volatility. So volatility and options kind of go hand in hand because volatility goes into pricing option. derivatives, they're kind of two main types of derivatives, they're linear derivatives, which go up a dollar, down a dollar, which is futures or forwards or swaps.

Starting point is 00:14:13 And those are typically, I think of them as like credit card exposure, where you get more exposure than what you pay for, right? And they go up a dollar, down a dollar. The options markets are non-linear derivatives. So they don't have that same linear payout. they have asymmetrically payouts. They can have asymmetrically positive payouts or asymmetrically negative payouts. When you sell options, you're selling volatility.

Starting point is 00:14:40 And that's the thing that I'm trying to stress to investors who have things like the Ag Index is you are embedded short volatility, specifically fixed income ball with that exposure because homeowners are along the option to prepay. And owners of the financial mortgages are short options to homeowners. And whenever you're short options, your short ball. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future.

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Starting point is 00:19:10 All right. Back to the show. Interesting. You know, I find it a little ironic that we're entering this phase of tightening, But our current administration has just put policies in place to spend more to combat inflation and to forgive some student debt, which is essentially, in my opinion, a form of UBI or, say, a Stimmy check, if you will. I recently read someone even imply that this was even a form of moving the private debt

Starting point is 00:19:37 of the Fed to the public. And because they know they're starting to realize that repaying the debt they have would basically resort to hyperinflation. What is your non-political but general take on the effect of these current policies that are starting to play out? It's tough to say. I mean, obviously, a lot of people are hurting right now because of inflation, right? The cost of living is much higher. It's really hurting consumer confidence.

Starting point is 00:20:04 It's hurting small businesses. I think all of these policies are well-meaning, but it creates more of a wealth gap because think about the people who maybe didn't go to college. because they couldn't afford it, right? Now, those taxpayers who might be working at XYZ, whatever industry they are, their taxes are going to relieve the deaths of other people, right? So it's, I think, well-meaning policy, but it can have ramifications that, you know, aren't necessarily fair. Now, nobody said life is fair, but I think that's one thing I always think about is

Starting point is 00:20:40 when you give debt forgiveness, you're basically encouraging and rewarding those people who took on the debt to begin with. Yeah, and I wonder if colleges will just hike their prices 10,000 today. We'll see what happens, you know. What are some of your main concerns on the supply side? You mentioned the labor market is tight and supply chain still seem to be pretty chaotic. Is a supply side recession on the horizon? And what would happen in your opinion if we did start to see unemployment start ticking up?

Starting point is 00:21:10 You know, that could be the stagnationary outcome, right? that would be, you know, stagflation is a kind of a made-up word from the 70s when you had lower growth and higher prices, a combination of both at the same time. And you really can't rule that out, especially so far in 2022, we've had stocks and bonds sell off together. We've had two negative GDP prints, whether that's recession or not. I'm not going to go there. But, you know, we've had lower growth and higher prices. And so I think that's one of the things that investors just have to be careful of is not trying to make a bet about what outcome or what regime we're going to have in the future, but just being really diversifying to have, be prepared for a lot of different

Starting point is 00:21:54 outcomes because nobody really knows, right? If, you know, inflation is not a U.S. only thing. It's very much a, in the entire world is failing inflation. I feel very fortunate every day to be a citizen of this country and to have, you know, clean water and food and we can feed ourselves. as a country, you know, there are horrible things happening around the world with inflation and drought and starvation and famine. And it's a really tough environment. So I think it's just really important to whatever your view is about the outcome, just make sure you have diversification in your portfolio. So you're not betting for one specific, whether the Fed Heights 50 or 75 basis points. It doesn't matter. We're not day trading the number of Fed hikes here. We're thinking about, you know,

Starting point is 00:22:43 how to plan for our retirement, how to have enough, not outlive our savings, how to have, you know, good, productive lives, right? That's what it's all about. You mentioned bonds and stocks selling off at the same time. Is that, in your opinion, just a symptom of the stagnationary type of environment, or is the correlation between stocks and bonds sort of a thing of the past? It's unclear. I think that the problem with correlations is they can change, right? Correlations are just looking at like what happened in the past. And there's no guarantee that things are going to continue, like a lot of these model portfolios, like a 60-40 portfolio, which has typically 60% equities and 40% bonds, that assumption is that stocks and bonds are not going to

Starting point is 00:23:30 become correlated. If they do become correlated, the whole portfolio construction doesn't really work. And so I think that's where, you know, you should be looking at other things that can potentially help diversify that traditional 60-40 portfolio because we just don't know what kind of outcome we're going to have. I'm kind of curious what indicators you pay most attention to. Let's kind of talk about the yield curve and start there, whether it's the 10-year, two-year, 10-year, 10-year, three-month. But just in general, when you're looking at the environment, especially around treas,

Starting point is 00:24:02 what indicators are you paying most attention to? So I really like looking at the interest rate markets, as you mentioned, Trey, I think it's a very simple way to look at what the market expects in the future, right? The Fed, just like any central bank in any country, sets a policy rate. That's the overnight lending rate. That's a Fed Fund futures rate in our country. So currently it's 225 to 250 is a band. But where interest rates are at different points of time is the term premium. interest rates. And that's where lenders lend money, right? I think it goes down to the value of money

Starting point is 00:24:41 and what it costs to borrow money. Right now, the yield curve is fully inverted, meaning you can actually get paid more yield to own a short-dated bond than you can a long-dated bond. And that's really weird. If you take a step back and you're like, if you're lending me money, tray, and I say, can I borrow a thousand dollars and I'll give you, you know, say three percent, right? Let's say 3%. And I say, you know, actually, instead of borrowing money for a week, can I borrow money for 10 years? And you would say, okay, I'll charge you less to give you that loan. That doesn't make a lot of sense. So it's a very unusual environment right now where we have this inverted yield curve. It's not something that it's really, I think, a reflection of the rates market saying that the Fed is going to hike policy rates. and that's a policy mistake and that that's going to slow growth.

Starting point is 00:25:35 I'm not saying that's right, but that's what's priced in. Let's talk a little bit about that because to your point, the yield curve, these bonds are experiencing negative convexity, it would seem, and you are an expert on convexity. So I'd love if you could just explain to the audience myself, you know, like we're five, maybe, about what exactly convexity is and the implications of when a bond is experiencing negative convexity. Yeah, so all that means is house sensitive. So with a mortgage, a mortgage is often considered negatively convex because homeowners

Starting point is 00:26:09 are on the option. So you can think of convexity as a way of thinking about how your payoff is. So it's very important for looking at in fixed income exposures to have things that are not only short optionality and something that's positively convex. most investors only have negative convexity in their bond portfolio. It's a complicated concept, but it has to go down to the payoff. If your payoff is positive, meaning you can make more than you can lose, that's positively convex.

Starting point is 00:26:41 Or if you could lose more than you can make, that's negatively convex in a simple way. So in a time like this, when you are seeing inflation near 40-year highs and interest rates are around 3%. How do you play the potential normalization that? may occur? Yeah. So we created a fund access that market. It's something that was previously something that most people couldn't access on their own because it's the interest rate market. It's more of a traditionally institutional market. Most, you know, whether it's a corporate or a sovereign, you know, around the world whenever an issue or a bond issue or somebody sells bonds in US dollars,

Starting point is 00:27:21 they go and hedge their interest rate risk. They don't sit there and say, oh, geez, we hope. the Fed doesn't hype rate, so immediately go hedge their exposure in the interest rate market. So I think it's surprising to a lot of people, but the interest rate markets are huge. They're approximately five times larger than the U.S. stock market. It's a huge big market because think of every sovereign in the world, whether it's the ECB, Japan, the kingdom of Saudi Arabia, whether it's global corporate, AstraZeneca, Sony, everybody sells bonds in the world. And so it's a huge market is interest rate. That's really interesting. I mean, my only real experience with volatility or trading around it is like around the VIX.

Starting point is 00:28:05 And that seems to just have a negative trend forever because, you know, the stock market goes up 75% of the time roughly, right? So there's going to be those pockets where it performs really well. But trying to time that seems very hard to do. And I did see this chart the other day. that's a little ominous where the VIX is kind of tracking almost perfectly to these 2008 levels. And within, you know, maybe a few more months, there's this huge spike from the 2008 chart. And it kind of looks like we're heading that way. So is something like volatility, something you advise people to take a position on around this time, just given the current environment and the risks that are in play? I don't, I'm not trying to give financial advice

Starting point is 00:28:45 about speculating on the level of volatility. The thing I want to educate people on is most, it's not equity of all that you should be worried about. It's actually fixed income ball because most people are short fixed income ball inside their bond portfolio. And that's the negative convexity. And positive convexity is something that I think is very good to have as part of a diversified bond exposure. What that means with positive convexity is when you make money and that instrument moves in your favor, you make even more. So it grows exponentially positive. Most people are only short fixed income volatility because of their mortgage risk. And I think it's especially dangerous time to have that exposure moving into even more quantitative tightening in September with the caps increasing.

Starting point is 00:29:32 That can be ball increasing. We've seen interest rate volatility move higher, whereas equity volatility has not moved higher this year. I think it's really a trend that who knows whether it's going to continue. But with quantitative easing, it was very fixed income volatility reducing. So it's logical to say with quantitative tightening that it will probably increase the level. You know, just think about it. If you don't have that everyday big buyer in the market, it would seem like volatility would increase, especially if the Fed does start to maybe sell some of their balance sheet. Like they've talked about selling mortgages or not owning mortgages long term on the balance sheet.

Starting point is 00:30:14 So, you know, a long option is positive convexity. So just to go back to that concept again, that means if the. Underlier moves, say 1%, you won't make 1% like a linear derivative. You might make 0.5, which would be at the money option. But if it moves another 1%, you make more than that 0.5. It has that positive payout. As the asset cost moves, you can make more than you can potentially lose. Whereas negative convexity is the opposite.

Starting point is 00:30:45 So when you start to make money, the next step is you make less. You know, tips seem to be so irrelevant for so long that I think some people have kind of forgotten they exist. Are tips something retail investors should seriously consider at a time like this? I'm not sure about retail investors. Some retail investors might prefer there is an inflation, a different type of inflation protected bond, but it's limited to $10,000. So I think it depends on how much money, if you have less than $10,000, it might be better to use that other inflation protected bond. Tips are Treasury inflation protected securities. That's treasury inflation protected securities.

Starting point is 00:31:25 That's the acronym for tips. So they are treasury bonds, but they reset with the level of CPI, which is a consumer price index. So it's a relatively new market. A lot of people look at commodities to add inflation protection to their portfolio because they existed in the 1970s. I think the right thing to keep in mind about tips is they were only invented. by the US Treasury in 1997.

Starting point is 00:31:53 So they're relatively new instruments, and a lot of investors just don't have them because they're not part of those passive benchmarks, whether it's an active fund or a passive fund. Most fixed income funds are benchmarked to the Ag Index. And the Ag Index was created before tips, and there are no inflation protected bonds in the ag, and it's only that negative convexity from mortgages. So it's just important to know what you own inside the portfolio and don't go by just because it says core fixed income, it might not be as diversified as you actually think. What you're referring to right there, I would say, is something like the Ag Index, right?

Starting point is 00:32:32 And so a lot of folks, whether it's the ag or something else, are very bullish on passive ETFs. What are some of your observations around passive ETFs and you mentioned the mortgage risk? What are some other risks around just holding passive ETFs? I think the problem is just they, there's nothing wrong with passive strategies. In the case of the ag, there's no inflation protection in it at all. It's only short volatility because of the, about a third is U.S. mortgages. And so I think it's just you can have your core holdings be passive indexes, but you want to also understand what they are, so you can augment it based on your own personal risks.

Starting point is 00:33:12 Many investors, I don't think, realize that the ag is short-val, and I don't think a lot of people realize that the ag has no inflation protection inside of it. So I noticed that your ETF I-VOL is fairly uncorrelated to equities and even the ag index. What explains the lack of correlation here? It's something different. It's not, nothing in I-VOL is in the ag, so it's logical. Again, correlations are historical, so there's no guarantee that it will continue to be non-correlated, but at least what it has inside of it, which is about 80% of the fund, is in TIPS, which is a type of

Starting point is 00:33:52 treasury bond, and then it has exposure to the interest rate markets. And that's not in the ag. So it's logical that it wouldn't be correlated to the ag because it's something different. So here's a fun question. In your world, your expertise, what are the things? that people should understand about the volatility markets themselves? So anytime somebody talks about a volatility market, they're talking about an options market. It's sort of like, do you use a Kleenex to wipe your nose or do you use a tissue?

Starting point is 00:34:23 It's really the same thing. So in order to have a volatility market, you have to have an options market because volatility goes into pricing options. So I think it sounds like a very complicated thing, but it just means non-linear derivatives, which are options. Most people have linear derivatives inside of their bond funds, whether it's a future or a swap or forward. All of those go up a dollar, down a dollar, and they're linear derivatives. Options are non-linear derivatives that use volatility to go to pricey options or for their ball markets.

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Starting point is 00:38:19 All right, back to the show. I think a lot of people think about volatility, maybe on the downside, maybe not so much on the upside. But with your strategies, are you making money on whichever way the market's going in that way, the volatility market? Yeah, so you're right. People use volatility to talk about the historical standard deviation of pruchurance. So there's volatility, what I'm talking about is its own asset cost.

Starting point is 00:38:43 It's like what is in the options market. And so for our strategies, they're all. all long volatility, meaning we own options. And when you're long volatility, you can actually profit from higher volatility. So it's like owning, you know, there's realized volatility, which is what's happening previously. And then there's implied volatility, which is what's happening in the future. So we own options. Therefore, we are long fixed income volatility. It's not the VIX. The VIX is equity volatility. In fact, it's one specific index for equity volatility. There are lots of different types of volatility, any place that there is an options market, there's a

Starting point is 00:39:22 wall market. And I think that's what I keep going back to the core fixed income or the ag. Most people are only short fixed income volatility in their bond portfolio, which I think is part of our thing, you know, standing on our soapbox, trying to educate investors, is that you have to understand your bond portfolio is probably short volatility. And you might want to do something to help at least neutralize that without taking a bet that fixed income ball is going to fall, right? Because when you're short volatility, you're betting that fixed income volatility is going to go down. It might not be going down anymore, especially with QT starting in a bigger way. I think I'm getting a sense of maybe why you started the I-VOL ETF, just to that

Starting point is 00:40:07 point, educating people, getting this trade in place, if you will, that people seem to kind of be missing, which is, again, a little hard to wrap your head around, but I'm kind of interested in how you've pivoted your career into this ETF business and what kind of drove you to get it up and running? So I started my career at Goldman in the late 90s, and it was right when the U.S. Treasury invented this tips market, the Treasury inflation protected securities. And I remember being a young trader and just thinking, like,

Starting point is 00:40:38 that makes no sense. You know, it's tips are bonds. So they are treasury bonds and they will lose money when interest rates go higher based on their duration risk. So I was like, that's not necessarily the best way to be thinking about hedging inflation with a product that will lose money based on their duration exposure. So I wanted to solve instead of many investors use short duration, right, just when they're worried about interest rates going higher, they buy short duration.

Starting point is 00:41:08 But I feel like that strategy is kind of, it's almost like a fake name. Because it's not short anything. It really should be called less long. Because anytime you have a bond, it's long duration. It's just a question of how long duration it is. So I wanted to create a product that could actually benefit from long-dated yields going higher, which is when the tips will lose money based on their duration. But I also wanted to give investors exposure to have a positive convexity fixed income fund

Starting point is 00:41:37 instead of just being short convexity with mortgages. And inflation is really. really a risk on asset cost. That's why we like using fully funded options because A, we're long fixed income volatility. And B, inflation is not like buying a stock, right? It doesn't have zero. It can go below zero. It's a very risk on asset cost. You can lose quite a bit of money in inflation, whether it's, you know, commodities, oil went negative during the pandemic. Inflation tends to fall when equity is still off. And so I like using the long fixed income volatility is a way of potentially reducing the volatility of tips by themselves.

Starting point is 00:42:16 We've seen the yield curve invert a few times this year. You mentioned it's fully inverted right now. You were quoted a year ago talking about the stagflation environment very early. I'm kind of curious, what were the signs even before the yield curve that you were maybe looking at to make such a call like that? I think it's the old thinking about 60-40 portfolios that concerned me because I was like, look, if we have stagnation, that is going to make stocks and bonds sell off together. And I think a lot of people count on that 60, that traditional 6040 portfolio to be diversifying. You know, the whole point of asset allocation is to not lose money on everything all at once. And that's exactly what's happened in 2022. So it was something,

Starting point is 00:43:02 again, I always think correlations are just, that's history, right? It's what's happened in the past. And there's no guarantee that correlations will continue to behave the way they have historically. And I think the stagflationary environment is especially dangerous for the 6040 portfolio. And I just wanted to alert investors to that risk. And obviously, nobody wants stagflation, but it's unfortunately really played out for a lot of investors this year with stocks and bonds selling off together. With the inflation where it is, I think traditional thinking leads you to think hard assets. right, real estate. You mentioned some risk around that because you're short of volatility. But I'm kind of curious what your opinion is on hard assets in general during a time like this as

Starting point is 00:43:48 either a hedge up to inflation or a safe haven, however we want to call it. But just generally speaking, is there anything in the hard asset realm that you would kind of potentially consider for a portfolio? I mean, I think most people have exposure to real estate, whether they own homes or whether they're renters, they have a kind of a step in the hard asset from, you know, we all need a place to live, right? So I think most people have that in their exposure. I think commodities are used a lot for inflation because they existed in the 70s, whereas the inflation protected bond markets, the inflation markets didn't even exist back then. So I think a lot of people are not looking at inflation or interest rates for that

Starting point is 00:44:34 exploitation exposure because it's newer. It's a newer market. You know, the interest rate derivative markets didn't really even start until the 2000s. So I think it's just important to be focused on diversification and commodities, you know, are fine and real estate is fine, but you might want to think about other things as well because we just don't know, you know, what's around the corner. And I think it's especially important for people who are retired because they're not going to be benefiting from wage inflation because they're not in the labor market anymore. And they probably have more of an allocation to fixed income. So they're even more at risk that inflation turns out to be not something that's falling, which is what's priced in right now. The inflation markets are

Starting point is 00:45:20 pretty complacent right now that the Fed hiking policy rates and being as hawkish as they have been will slow inflation and it's priced in. Now, I've heard you talk about oil and similar to gold as sort of a technology and they're easier and easier to come by because technology it gets better over time and it's easier to access these resources. But there's a lot of narrative out there that would say otherwise, for example, OPEC seems to be hitting capacity. There hasn't been much investment in new oil drills or rigs over the last five years. And Warren Buffett has even come out really strong on this bet, being bullish oil, it would

Starting point is 00:45:59 seem, with his consistent investments in now Chevron. but also Occidental and it just increased his potential position to 50%. I'm kind of curious, when you see that stuff playing out in the headlines, does it make you rethink where inflation might be able to go from here, just given oil being such a big driver of it? Yeah, I mean, oil is a huge driver because we are not, the infrastructure is not there around the world. Also, the geopolitical situation in Europe is creating, you know, the real problems in the energy space. So I'm not saying those are bad investments.

Starting point is 00:46:35 It's just commodities are not the only way to think about inflation. That's my point. I'm not saying don't have commodities in your portfolio or don't have energy stocks in your portfolio. Those are fine. But just like anything else, you don't want to plan on that alone working. It's just what everybody has been running to because that's what worked in the 70s. And that's the only period of high inflation that we have to look at.

Starting point is 00:47:00 And I think going forward, when people look back and they look at tips, which are the Treasury inflation protected securities markets, they're going to be disappointed, in my opinion, because I don't think tips will really provide that inflation protection because of their duration exposure. And that's where Ival tries to help to say, look, we're going to give you another measure of inflation, which is interest rate where lenders lend money, which is currently inverted, right, that inverted market plus access to fixed income long volatility instead of just being short volatility. So it's just something different. I'm not saying, you know, you don't want

Starting point is 00:47:39 to have everything being the same way and you don't want to have everything as one bet. So I think oil, you know, 20 years from now, let's just put that. Like if you're, you know, say you're 70, right, reasonable to expect you only have 20 years left in your life. So maybe oil, is fine for people like Warren Buffett, but say you're 22 and you want to have inflation in your portfolio, oil may not be the best long-term holding because eventually there will be infrastructure build-out and eventually there will be a way more supply will come online. Maybe OPEC will break. It is an oligopoly here, right? It's a pricing cartel. So you just don't know what's around the corner. So I'm not saying energy is a bad thing to have in your portfolio.

Starting point is 00:48:27 it just might not be the only thing that you should have to express inflation. Thank you for the clarification. And it's an interesting point because commodities are, they've been a great trade over the last couple of years, but they're getting to near all-time highs, it would seem. So depending on the commodity itself, I'm kind of getting a better idea of where Ival fits into a portfolio because that's kind of what I'm trying to get a feel for that here, because it seems like it's this hedge almost in a lot of ways, which I would think would be somewhat of a small position in a portfolio.

Starting point is 00:48:57 So in the 6040 kind of going away, commodities, maybe not being a focus. Equity seem to have a lot of risk. So I'm just trying to get a feel for where retail investors should really, I guess, wait. And it's not financial advice, but which assets, given the current environment, are going, your opinion, to perform the best, I guess, say over the next 10 years? I mean, I would say a lot of people, the way that they're using eyeball is to complete their core fixed income. So if they have, you know, let's just say $100 allocated to the ag index, the ag has no inflation protected bonds, it's only short volatility. They might say, all right,

Starting point is 00:49:38 we'll take a third of that exposure and add eyeball to make it a more complete, a more diversified portfolio by adding inflation expectations in the future, adding, you know, long volatility to neutralize the short ball in mortgages to help diversify the portfolio. So I think most people are using it not as a bet, so to speak, but more as a diversifying completion portfolio. Another interesting point about Ival I'm seeing is that it's got this distribution that I find to be somewhat uncommon. What's driving your ability to give those coupon payments out to investors? So Ival has paid a minimum monthly distribution of 30 basis points since July 2019. So we've paid 30 basis points minimum every month for the past three plus years. That is a different

Starting point is 00:50:33 type of most investors to augment government bonds. They take credit spread risk, right? So whether it's high yield, investment grade, levered loans, splitting rate notes, all those things are taking corporate credit spread risk. We don't take corporate credit spread risk. We take interest rate spread risk. So it's just something different. And that is also tip CTFs often don't pay monthly distributions because tips are a variable yield product. They reset with the consumer price index. So you can look at the monthly distribution on tips. In 2020, there was no distribution paid out for most tips CTFs until September or October. So you had the bulk of the year with no monthly distribution. I've also had a more of a steady monthly distribution that is potentially enhanced above tips alone.

Starting point is 00:51:29 One last clarification around the duration of bonds. Can you just walk the audience through how the durations change or how people position themselves differently based on the interest rate volatility? Yeah. So duration, very simply, all bonds are long duration. even a shorter dated bond is still long duration. So short duration really should, in my opinion, be called less long duration. And duration is the bond's sensitivity to a one basis point change in interest rate. So if interest rates move higher, bonds lose money in price terms. So for instance, you can look at any of the treasury or investment grade or high yield or Muni or pretty much all bonds are down this year in 2022, and most of the losses have been from higher interest rate.

Starting point is 00:52:21 Credit spreads have widened a little bit, but not very much. It's mostly from rates. And so I think it's just really important for investors to understand that all bonds are long duration and when interest rates move higher, traditional bonds will lose money. Ival has a way to profit from either lower front-dated yields or higher long-dated yields. So the treasuries that we own are just bonds, right? So they want real yields lower because they're bonds, which means prices higher. But the options inside of it don't really care about the level of interest rates. So if interest rates were, say, 4% or 10% or 1%, it doesn't really matter.

Starting point is 00:53:04 To the options, the options just want the spread between short and long-dated rates to widen. So it's just a different type of spread risk. instead of only using corporate credit spread risk inside of bond portfolios. Okay, Nancy, so before I let you go, and first of all, thank you so much for this education, it's something that I've been trying to learn a lot more about. Before I let you go, though, I'd like to give you the opportunity to hand off to our audience where they can follow along with what you're up to, your E-TF, I-VOL, and any other resources you want to share?

Starting point is 00:53:36 Sure. So we have a fund website, which is Ivaletf.com, where investors can see our prospectus and our SAI. Our materials are there as well under the materials tab, like our fact sheet. And that's a good use. I'm recently new to Twitter. I just joined Twitter about three months ago. So I have, I guess it's like a bot hashtag because I did a double underscore, but you can follow me at Nancy double underscore Davis at Twitter. I also use LinkedIn. And our website also has a contact us page. So if you want to be added to our distribution list to receive our quarterly letters or any any materials that we send out, you can sign up on the eyeball etf.com website.

Starting point is 00:54:25 Nancy, you've opened my eyes to how the markets are pricing in these Fed actions. And I'm really eager to see what happens next. So I would love to have you come back on after we kind of, you know, the dust settles maybe in the last next few months. and we kind of have more insight as to what the Fed is currently thinking. So Nancy, once again, thank you for coming on the show. We appreciate it. Thank you, Trey. Thanks so much for having me on.

Starting point is 00:54:45 It was great to have this discussion today. I hope it was helpful to your audience. All right, everybody, that's all we had for you this week. If you're loving the show, don't forget to follow us on your favorite podcast app. And if you'd be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter at Trey Lockerby. And don't forget to check out all of the amazing resources we've built for you at the

Starting point is 00:55:05 investorspodcast.com. You can also simply Google TIP finance and it should pop right up. And with that, we'll see you again next time. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP473: Using Volatility to Hedge Against Inflation W/ Nancy Davis

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