Inflation ETF pioneer says investors need more interest-rate risk

Nancy Davis was a trader at Goldman Sachs Group Inc. and a fund founder before she made a splash with IVOL, an actively managed exchange-traded fund that allows investors to bet on inflation and interest-rate volatility. The Tampa native says she’s loved the nonlinear risk of options trading since she was in college at George Washington University.

Today her firm, Quadratic Capital Management, no longer manages hedge fund money. Instead Davis focuses on overseeing the IVOL strategy, which had about $3.56 billion as of mid-November, and a deflation strategy, BNDD, that opened in September.

Davis, 45, spoke with Bloomberg Markets in October about her career, why fixed-income investors need volatility exposure, and her relationship with fellow active ETF manager Cathie Wood of Ark Investment Management. The interview has been condensed and edited for clarity.

How did you get your start in finance?

I started my career at Goldman Sachs right out of college. I didn’t have any connections to Wall Street. I remember telling my father that I was moving to New York to work for Goldman Sachs, and he thought it was a horrible idea: 'They’re going to eat you alive, why do you want to go there?' I was very fortunate to move into a trading seat on the proprietary desk managing Goldman’s own capital. We had no clients. It was a really great learning opportunity to invest across all asset classes and get exposure to many different things. It was also a great place to be as a woman, as a trader, as an investor.

Did you always want to go into finance?

I didn’t know anything about this industry, nor did I think this is what I wanted to do when I grew up. I was a scholarship kid, and I also had a job [a paid internship at Ernst & Young’s consulting business] where we were doing a lot of things with derivatives. Because of my scholarship I could take classes in the grad school, so I ended up taking, I think, five grad classes as an undergrad. I learned all about derivatives for my job and started trading options personally first. I think it made my résumé stand out when I applied to Goldman as well as other firms. I was always very interested specifically in options. There are a lot of different types of derivatives. Most investors use linear derivatives like futures, forwards, swaps. Those are derivatives that go up a dollar, down a dollar, right? I don’t really have much interest in linear derivatives. I’m 100% an asymmetric girl. So all options, all asymmetric payouts.

Why do you like options so much?

Most portfolio managers manage their portfolio with stop losses. They create a portfolio, and then they stop-loss the portfolio by selling their longs after they’ve sold off, covering their shorts after they’ve rallied. But to me, that always seemed stupid. You should create your stop loss at the beginning. And that’s what we do with options, right? We know our downside. Most portfolio managers first lose investors’ money, and then they risk-manage it.

Why did you leave Goldman?

I found myself commuting 3½ hours round trip every single day to Lower Manhattan from Connecticut. I wasn’t looking for a job. But then I remember getting recruited by JPMorgan’s hedge fund Highbridge and [being] asked, 'What in your life could be better?' And I said, 'I want to see my kids more.' And he said, 'We’ll open a Greenwich office for you.' So it was totally for flexibility. So that was the only reason I left. It was purely just for my commute.

Why did you start your own firm?

I felt like I was making a bet on myself, which to me never seemed risky. I just was like, 'What I do is awesome, it’s really different, and I’m going to do it for myself.' You have to be a little bit optimistic as an entrepreneur, and if you don’t believe in yourself, nobody else is going to believe in you.

I’m very mathematical as a financial person, but you get to tap into a whole bunch of other aspects in the creative process when you’re running a company. I’ve learned a lot. It’s something that gets me fired up.

As a woman, sometimes you get put in these emerging manager buckets. I personally take offense because I’m not an emerging manager. I’ve been a portfolio manager for a long time.

Why did you create an inflation ETF?

[Treasury Inflation-Protected Securities] are set with one index. Why would you use the consumer price index as the only way to measure something so big as inflation? And TIPS are long duration. If you look at Q1, everybody was talking about inflation. TIPS lost money, that’s because they’re bonds and they have duration exposure. IVOL really solves a problem that investors have.

I had the kind of light bulb moment that having public liquid securities inside of a private fund wrapper didn’t make sense. The fees were too high. You didn’t have the liquidity or the transparency.

And many fixed-income investors are short volatility in their fixed-income portfolio because of their mortgage exposure. And they just don’t necessarily think about it. If you own a mortgage, you are short options to U.S. homeowners because U.S. homeowners can prepay whenever they want. When you’re short options, you’re short volatility.

So creating IVOL and BNDD are solutions, not taking my hedge fund and turning it into an ETF. These are long-only strategies — they’re just positively convex, long-only strategies rather than mortgages, which are, you know, negatively convex strategies. I do feel I’m like the modern-day Lew Ranieri, right? He was the guy who packaged up mortgages [into mortgage-backed securities]. There’s only two types of bond risk. There’s interest-rate risk, and then there’s spread risk. Both BNDD and IVOL take interest-rate spread risk. It’s not correlated to the AGG [the Bloomberg Aggregate Bond Index]. It’s not correlated to high-yield bonds. It’s not even correlated to the VIX or gold or the equity market.

Who are your customers?

Most of our clientele has been on the institutional side — a lot of endowments, a lot of very highly sophisticated investors. March 2020 was really a pivotal time for IVOL, because we had positive performance when many bond funds with credit-spread risk lost money. I think that was a little bit of a wake-up call for investors. TIPS sold off as well, because we had oil go negative and inflation expectations were falling.

How did the pandemic change things?

I do think the pandemic has been sort of lightning in a bottle for inflation, because we now have fiscal spending, plus we have all of the labor shocks. The Fed’s gone to an average inflation target. Before the pandemic, people weren’t really thinking about inflation. IVOL does more than just inflation, it also can do well when the Fed cuts rates, which is typically in an equity risk-off environment. But I think it’s been at least a door opener for people who are, like, 'Oh, maybe I should look at that.'

How did you decide on the 0.99% expense ratio for both ETFs?

A flat-fee product is really great for investors. That’s one thing that does differentiate active ETFs from hedge funds. Hedge funds are commingled funds that have a manager expense fee plus an incentive fee, and an active ETF is also a commingled fund that is actively managed, but our fee is flat. Our fee includes all the fund expenses like the admin, the custodian, the audit. All of those are paid by the ETF issuer, not the fund.

Why did you choose to work with Krane Funds, majority owned by China International Capital Corp.?

I started doing stuff with China back in my Goldman days, and then I wrote a paper that was published in a book in China. I was a keynote speaker at a conference. They had given the [chief risk officer] of BlackRock about 15 minutes. The CEO of [China Investment Corp.], their sovereign wealth fund, he got like 15 minutes. I had an hour and 45 minutes. It was just amazing to have so much support. At that conference, the Asset Management Association of China, I met someone who later ended up working at Krane. We reconnected when I was thinking about launching an ETF, and we also had a lawyer in common. There are a lot of operational things and compliance things that are very important, and with any growing business, you can build it internally or you can partner with specialists. I really wanted to focus on the portfolio side. It was a crazy, crazy coincidence that it was through China that I originally connected with them.

You’ve been compared to Cathie Wood. What do you think about that?

I don’t know of ever being compared to Cathie, but I love Cathie. She’s a fabulous person as well as a great investor. I started Quadratic a little before Ark was founded. She’s been a huge inspiration as well as a sounding board, and I think I’ve also been that for her. I haven’t embraced social media like Cathie. I have no Twitter account.