For most individual investors, IVOL’s strategy is probably too complicated and it has above-average expenses.
However, for investors who are seeking a niche strategy that will benefit under certain market conditions, then this IVOL could play a role in their portfolios.
Here is what you need to know before investing in the Quadratic Interest Rate Volatility ETF.
The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) is a newer exchange-traded fund that seeks to protect against inflation while providing additional returns using options contracts.
IVOL does not protect against rising interest rates, and investors shouldn’t invest in this ETF thinking it will do well if interest rates increase. Instead, the ETF provides an additional return if the yield differential between 10-year and 2-year Treasury bonds widens.
In other words, performance is driven by the change in relative interest rates, rather than just an increase in rates.
IVOL was launched in May 2019 and has quickly grown to nearly $800 million in assets.
Quadratic Capital Management is the subadvisor. The firm specializes in interest rate volatility and options strategies and was founded in 2013 by Nancy Davis. She previously worked for Goldman Sachs.
Crane Fund Advisors is IVOL’s sponsor. Crane was also founded in 2013 and has about three billion dollars in assets under management.
IVOL’s expense ratio is 0.99% per year. This expense ratio is higher than most ETFs, but given the complexity of IVOL’s strategy, the sponsor can command a higher fee.
How IVOL Works
IVOL’s inflation protection component is straightforward with 87% of its assets invested in the Schwab U.S. TIPS ETF (SCHP). IVOL earns interest on the inflation-protected bonds held by SCHP. IVOL also benefits from the principal increase in the Treasury Inflation-Protected Security (TIPS) based on the inflation rate. You can learn more about TIPS investing in this guide.
The options component of IVOL is more complicated. The ETF has 5% of its investments in seven constant maturity swap options, also known as swaptions.
A swap is an agreement between two counterparties to exchange a series of payments.
For example, one counterparty might pay the interest rate on 10-year Treasury bonds while receiving the interest rate on a floating-rate instrument.
The options used by IVOL are based on constant maturity swaps tied to 10-year and 2-year U.S. Treasury bonds.
In these swaps, one counterparty pays interest based on the 10-year Treasury bond yield while receiving interest based on the 2-year Treasury bond yield.
IVOL buys options on those 10-year and 2-year swaps. These swaptions are effectively an agreement to enter into a swap agreement in the future.
IVOL’s options have different payoffs. First, if interest rate volatility increases in that investors expect larger fluctuations in interest rates, then the value of the options held by IVOL increases. If interest rate volatility falls, then the options held by IVOL will fall in price.
The value of the options held by IVOL will also change if the spread or the difference between the yield on 10-year U.S. Treasury bonds and 2-year U.S. Treasury bonds changes.
If this spread widens in that either the 10-year Treasury yield goes higher, or the 2-year Treasury yield goes lower, these options will go up in value. If the spread narrows, then the options will go down in value.
In theory, if inflation expectations increase, then 10-year Treasury bond yields will increase more than 2-year Treasury bond yields. In that scenario, IVOL will benefit because the swap options it holds will go up in price. However, even if inflation expectations increase, there is no guarantee that 10-year Treasury bond yields will increase more than 2-year Treasury bond yields. There are times when 2-year rates might increase by more, particularly if the Federal Reserve is raising short-term interest rates.
A primary risk to IVOL is the yield curve flattens in that the spread between 10-year and 2-year Treasury bonds narrows, causing IVOL’s options to fall in price.
The risk would be compounded if the yield on both 2-year and 10-year Treasury bonds increases but the 2-year Treasury bond rises by more.
In this scenario, not only would the options fall in price, but IVOL’s investment in the Schwab U.S. TIPS ETF would also decline, compounding the losses.
IVOL also has leverage risk. Options contracts have embedded leverage in that the investor’s overall exposure to the underlying strategy that the options are based on is greater than the value of the options. In this case, IVOL’s swap exposure is greater than the value of the options it holds.
This increased leverage is reflected in IVOL’s higher volatility compared with its primary holding, the Schwab U.S. TIPS ETF (SCHP).
Finally, IVOL has pricing risk in that its market price can differ from the value of its underlying holdings as reflected in its net asset value (NAV).
ETF sponsors work with institutional investment firms known as authorized participants to try to keep the market price of an ETF in line with its net asset value through a share creation and redemption process.
For more complicated strategies like IVOL that utilize less liquid options contracts, it is more difficult for authorized participants to keep the market price near the NAV, leading to different returns for the ETF on a market price basis compared to a NAV basis. Sometimes the ETF’s market price returns are higher than the NAV returns and sometimes, the market price returns are lower.
From its inception May 13, 2019, through December 31, 2020, IVOL has returned 10.9% annualized on a market price basis compared with 9.5% annualized for its index, Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index (Series L).
IVOL benefited from the large decline in TIPS interest rates in 2020. IVOL is unlikely to return double-digits going forward unless TIPS yields fall even further into negative territory.
Should You Invest in IVOL?
IVOL is an intriguing way to benefit from higher interest rate volatility and widening spreads between 2-year Treasury bond yields and 10-year Treasury bond yields. The ETF had some differentiated return drivers but should not be confused as an investment to protect against rising interest rates as that is not its objective.
For most individual investors, IVOL’s strategy is probably too complicated and it has above-average expenses. However, for investors who are seeking a niche strategy that will benefit under certain market conditions, then this IVOL could play a role in their portfolios.
David Stein is the founder of Money For the Rest of Us. Since 2014, he has produced and hosted the Money For the Rest of Us investing podcast. The podcast reaches tens of thousands of listeners per episode and has been nominated for six Plutus Awards. David also leads Money for the Rest of Us Plus, a premium investment education platform that provides professional-grade portfolio tools and training to help individual investors manage their own investment portfolios. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David spent over a decade as an institutional investment advisor and portfolio manager. He was a managing partner at FEG Investment Advisors, a $15 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.