Rising tensions in the Middle East have renewed investor interest in volatility ETFs, which are designed to increase in value as expected market volatility rises. While VIX-linked ETFs are well known, they focus on equities and overlook fixed-income and interest-rate volatility, a meaningful component of most portfolios. The Quadratic Interest Rate Volatility and Inflation Hedge ETF (ticker: IVOL) is designed to address this gap.

How Does the IVOL ETF Work?

IVOL is managed by Quadratic Capital Management, an asset management firm founded in 2013 by Nancy Davis, which focuses on options and volatility markets.

IVOL was listed on the NYSE in 2019 as a fixed-income completion ETF, designed to address two structural gaps in the Bloomberg U.S. Aggregate Bond Index ("the Agg"), the benchmark tracked by most U.S. bond investors.

The Agg contains no inflation protection since there are no TIPS (Treasury Inflation Protected Securities) within the index. This leaves bond investors with a gap in their core fixed income. Another issue for investors arises from the fact that roughly one-third of the Agg is short interest rate options. This short position is due to the Agg’s allocations to mortgage-backed securities and callable corporate bonds. (In the case of mortgages, US homeowners are long the option to prepay their debt. And corporates can call their bonds, often just when bond holders would prefer that they didn’t.) IVOL was designed to complement core bond holdings by seeking to address both of these issues.

The fund combines two core exposures:

• TIPS and/or cash (at least 80% of the portfolio): U.S. Treasury Inflation-Protected Securities provide income that adjusts with the Consumer Price Index (CPI), seeking to help preserve purchasing power in inflationary environments, while serving as the fund's defensive core.
• Long OTC interest rate options (the remainder): Fully funded, long-only options on the U.S. interest rate swap curve, specifically the spread between 2-year and 10-year swap rates (known as "2s10s"), that seek to benefit from rising fixed income volatility and a steepening yield curve. Because IVOL is long options, it maintains long interest rate volatility exposure.

The yield curve is the relationship between short- and long-term interest rates. When long-term rates rise relative to short-term rates, the yield curve steepens. This dynamic has historically been associated with inflationary environments and, in certain cases, with significant equity market declines, as the Federal Reserve has at times cut short-term rates in response to economic stress.

How Is IVOL Different from a VIX ETF?

VIX-linked ETFs track short-term futures on the CBOE Volatility Index, which measures expected equity market volatility derived from S&P 500 options. They have historically spiked during acute equity selloffs, but they carry a structural cost known as negative roll yield which causes them to erode over time, making them better suited as short-term tactical tools than long-term portfolio allocations. They also generate no income and offer no exposure to inflation or interest rate volatility, leaving significant gaps for investors seeking broader risk management.

IVOL differs from VIX ETFs in several ways:

• Different volatility exposure: IVOL targets interest rate volatility through the fixed income options market, not equity volatility through VIX futures. These are distinct risk factors that may respond differently to various market conditions.
• Income generation: Unlike VIX ETFs, which generate no income and may erode through roll costs, IVOL's TIPS allocation seeks to provide inflation-adjusted monthly income distributions.
• Inflation exposure: IVOL is designed to provide inflation-linked exposure through its TIPS holdings and swap curve options. VIX ETFs do not offer inflation-linked exposure.
• Yield curve positioning: IVOL is designed to potentially benefit from yield curve steepening, which can occur both when long-term rates rise and when the Federal Reserve cuts short-term rates in response to economic weakness. VIX ETFs have no yield curve exposure.
• Long-term portfolio suitability: Because IVOL uses fully funded, long-only OTC options rather than rolling short-dated futures, it is designed to function as a strategic portfolio allocation rather than a short-term trade.

Why Consider IVOL in a Portfolio?

The traditional 60/40 portfolio assumes that bonds will provide stability when equities sell off. As 2022 demonstrated, that relationship is not guaranteed. When inflation is a primary driver of market stress, stocks and bonds can decline together, potentially leaving investors with limited diversification.

IVOL is designed to address this dynamic, seeking to provide a differentiated return profile in environments characterized by rising inflation and rising fixed income volatility. Key potential portfolio considerations include:

• Inflation exposure: TIPS holdings provide income and principal that adjusts with CPI, while swap curve options seek to add market-based inflation expectations beyond what CPI alone captures.
• Interest rate volatility exposure: Long OTC interest rate options seek to potentially benefit when fixed income volatility rises.
• Yield curve steepening exposure: Designed to potentially benefit whether the yield curve steepens through rising long-term rates or falling short-term rates.
• Fixed income complement: IVOL is not designed to replace a core bond allocation but to complement it, seeking to address the inflation and volatility gaps that Agg-based funds may leave open.
• Institutional market access: IVOL seeks to provide individual investors with exposure to the OTC fixed income options market through a liquid, exchange-traded structure.
• Defined options cost: The use of long-only, fully funded options means the maximum loss on the options portion is limited to the premium paid.

An investor holding a 60/40 portfolio might consider allocating a portion of the bond sleeve to IVOL, for example, 30% Agg and 10% IVOL. However, the appropriate allocation will depend on each investor's individual circumstances, risk tolerance, and objectives. The right framework for evaluating IVOL is not whether it outperformed the S&P 500 in a given year, but whether it fulfilled its intended role within the broader portfolio.

Key Risks and Considerations

IVOL is not risk-free. Investors should carefully consider the following before allocating:

• Interest rate risk: The TIPS component is sensitive to changes in real interest rates. If real yields rise significantly, TIPS prices can fall.
• Inflation risk: If inflation remains low or declines, the benefits of TIPS and inflation-linked exposure may be limited or negative relative to nominal bonds.
• Options risk: The interest rate options can lose value or expire worthless if the yield curve and rate volatility do not move as anticipated.
• Cost: Strategies involving OTC options and active management typically carry higher expense ratios than plain-vanilla bond index funds.
• Strategy risk: IVOL's performance depends on Quadratic's approach to structuring and managing the TIPS and options book. Outcomes can differ from investor expectations.

Conclusion

For investors looking for a volatility ETF that goes beyond equity market hedges, IVOL offers a differentiated approach: inflation-linked income, long interest rate volatility through a market that has historically been largely inaccessible to individual investors, and yield curve positioning that may offer a distinct return profile across a range of market environments. As with any investment, results will vary, and there is no guarantee that IVOL will achieve its investment objectives.

---

For IVOL standard performance, top holdings, risks, and other fund information, please click here.

Definitions

Treasury Inflation-Protected Securities (TIPS): U.S. government bonds whose principal value adjusts with changes in the Consumer Price Index (CPI), providing investors with inflation-adjusted income and principal. At maturity, holders receive at least the original principal.

Yield Curve: A line that plots the interest rates of bonds with equal credit quality but differing maturity dates. A steepening yield curve occurs when the gap between short-term and long-term rates widens.

VIX (Cboe Volatility Index): A real-time index that represents the market's expectations for volatility in the S&P 500 over the next 30 days, derived from S&P 500 options prices.

Over-the-Counter (OTC) Market: A decentralized market where financial instruments are traded directly between parties rather than through a formal exchange, historically accessible primarily to large institutional investors.

Roll Yield: The gain or loss generated when a futures contract approaching expiration is replaced with a longer-dated contract. Negative roll yield occurs when longer-dated contracts are more expensive than near-term ones, creating a potential structural cost for investors holding futures-based products over time.

Bloomberg U.S. Aggregate Bond Index ("The Agg"): A broad-based, market capitalization-weighted bond market index representing intermediate-term investment-grade bonds traded in the United States, including Treasuries, government-related and corporate securities, and mortgage-backed securities. Inception date: January 1, 1976.

S&P 500 Index: A market capitalization-weighted index tracking the performance of 500 leading publicly traded companies in the United States, broadly representing the large-cap equity market. Inception date: March 4, 1957.