Extremely complicated new ETF hedges against everything: inflation, volatility and interest rates
A new ETF from Quadratic Capital Management, an advisory firm headed up by Nancy Davis, famed for predicting the short volatility bubble and the tech correction, will attempt to hedge against inflation, interest rates rises and volatility all while providing solid income. The Quadratic Interest Rate Volatility and Inflation Hedge ETF (HCPI) will be actively managed run as a white label with help from ETF Series Solutions.
The fund will invest primarily in a mix of TIPS and long options tied to the shape of the interest rate yield curve (which has inverted as of today). The strategy aims to hedge against inflation risk and make money from options when interest rate volatility increases or the yield curve steepens.
The options are expected to:
(i) appreciate in value as the swap curve steepens or interest rate volatility increases and
(ii) decrease in value or become worthless as the swap curve flattens or interest rate volatility declines.
WTF is a swap curve? (We’d never heard of it).
Well, a swap curve shows the difference between swap rates (i.e., the fixed interest rate exchanged for a floating interest rate in an interest rate swap) applicable to debt instruments with different maturities.
It is kind of like a traditional bond yield curve, “but instead of reflecting the fixed interest rates on debt instruments of specified maturities, [it] reflects the fixed interest rates used in interest rate swap agreements related to such instruments,” the prospectus says.
The swap curve gets steeper gets “steeper” when the spread between swap rates on longer-term debt instruments and shorter-term debt instruments widens and “flattens” when such spread narrows.
When the fund purchases an option, it pays a cost to purchase the option. As the fund will buy options over the counter (OTC) it may only have to pay a very small premium — or no premium at all. As a result, the options it invests in are “generally are subject to greater credit risk,” the prospectus says.
The options will also have to be rolled, as the old ones expire and new ones are bought. This may also trigger contango.
Analysis – too smart by half?
Nancy Davis, the boss of this ETF. She’s picked two out of three of the major bubbles of the past 12 months: short volatility and predicted the tech correction. (I’m sure she picked the bitcoin bubble too, but that one was so obvious that even David noticed it). This ETF is also very clever – but we’ve got to wonder: is it too clever?
The market for this ETF will have to be retail investors. Institutions can just do this sort of thing themselves. Yet retail investors may look at this and wonder what’s going on. Both of us have been working in finance for a while and we’d never run into the swap curve. Having read the prospectus, we only half get it and only one-quarter get how it may effect our investments. Which makes us both wonder: who’s going to buy this if they don’t understand it?
Maybe there’ll be some advisers somewhere craving for this type of solution. But we feel there is going to be a lot of educational legwork involved getting this thing sold.