Listen: Masters of Risk | Episode 10: Masters of Risk-Nancy Davis

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Yashi Yadav

Welcome to Masters of Risk, the podcast where we uncover what is top of mind for business leaders today. I'm Yashi Yadav and I will be your host every month. Let's get started. Hi, everyone, and welcome to another episode of Masters of Risk, a podcast by S&P Global Market Intelligence. My name is Yashi Yadav. I will be your host today. And joining me is Nancy Davis, Founder and CIO of Quadratic Capital. Nancy, I'm so excited to have you on today. How are you doing?

Nancy Davis

Thanks for having me on.

Yashi Yadav

So just to kind of -- let's get right into it, let's kick things off. Would you maybe share a little bit about your background. And I know you are, as I mentioned, the founder of the firm. So what prompted your decision to start your own asset management firm.

Nancy Davis

Well, I think it, it was -- it really is the American dream, right? So like build a business, and I think I had the confidence enough to say, "Hey, I'm pretty good at what I do. I think I'm one of the best out there." And I really want to hang my own shingle, and I started the firm about 11 years ago, and it's just been amazing. It really is the American dream.

Yashi Yadav

And what were you doing prior to starting the firm Nancy?

Nancy Davis

So I spent most of my career prior to my own firm at Goldman Sachs. I was there for about a decade. And I -- they don't exist anymore, but most of my time there, I was on the proprietary debt. So we had no clients. We were just investing Goldman's own capital on behalf of the firm.

Yashi Yadav

Got it. Okay. That's really interesting. I'm sure you learned and took -- were in a lot of different interesting situations and probably took on a variety of different risks while you were sitting on that desk. Was there anything while you were at Goldman that kind of inspired you to make the next move? Or was it just you were looking for a change?

Nancy Davis

Yes. I -- there are a lot of things that inspired me. And I think it's a very entrepreneurial group to be in as well. And I also saw a lot of my other colleagues at Goldman Prop who left the firm and started their own firm.

So I had a lot of great -- sometimes it's really -- and I think that's a great thing about being a guest on your podcast is I hope that we can inspire even one of your listeners to say, take the plunge and do it because it's so exciting. It's been a wonderful experience. And I actually have been working for my own firm now longer than I worked for Goldman because I was there about 10 years, and I've been -- Quadratic's been running for -- since 2013.

Yashi Yadav

Well, that's quite a feat. It's so interesting when you look back and just realize how much you've accomplished since then and kind of where you started and where you're at now. When you made the shift into starting your own firm outside of obvious of the entrepreneurial spirit and being able to see colleagues that had done it and been successful, was there a particular problem that you were looking to solve or a gap that you were trying to fill?

Nancy Davis

It's a great question. Yes, whenever you, I think, start a firm or do something because starting your own firm is risky because you have to quit your job and you go from being paid to work to paying to work, right?

It's not like you're profitable right away. So you always -- I think it's super important to always have a problem that you're solving, right? And I think that was where our niche really came in is that we innovated in the financial markets.

And sadly, there is not a lot of innovation in the financial market, but I think that really goes back to the core of the success that we've had because we are solving a problem that exists for people. And when you give -- no matter what industry you're in, right, it could be any type of industry as long as you're solving solutions for your clients and bettering their outcomes, that's what really matters.

Yashi Yadav

And as much as you can say, I know typically there is certain -- there's an extent to which you can share your investment strategies and there's others that's the secret sauce. But I guess, what specific innovation are you referring to in this scenario?

Nancy Davis

Yes. No, I'm definitely a full -- I think it's very important to be fully transparent. So I'm not one of the -- I know some portfolio managers like to have the mystique of trust me, we're not going to tell you anything and trust the process.

I'm definitely the opposite of that. I really spend a lot of time on education and I want people to understand exactly what we're doing and the investment process and sort of what it's trying to solve.

So when I started my career, it was right when the U.S. Treasury department started the inflation-protected bond market. It was in the late '90s, and I was a young trader at Goldman. And I remember thinking, wow, that doesn't make any sense, that's stupid.

So TIPS, which are -- is the acronym for Treasury Inflation-Protected Securities, they just started recently. Like if you think about it, like I'm not that old, but a lot of people look at what happened in the '70s and '80s to measure inflation. And I like to grab people and be like, look, there was no inflation-protected bond market in the '70s and '80s. There was no rates market in the '70s and '80s. So people look at things like commodities because that's all that existed. And so I think it's really important to say like these markets are pretty new.

One of the big problems we are trying to solve is the only index that's used within the treasury inflation protected securities is the CPI index, right? It's just like S&P, you have a lot of different indices, right?

There's not just one index and inflation is an incredibly complex and difficult thing to measure, even the Fed doesn't use the CPI index alone, right? There are lots of other ways to look at inflation.

It's really hard to measure it. And so I thought it makes no sense to have only CPI inflation being measured. And then the other big problem with TIPS is that all TIPs are long duration, right? They're all bonds, and they will all lose money, win interest on their duration exposure.

So we're trying to solve for the problem with TIPS having duration. And a lot of people will try to do that or they will say, okay, we'll buy TIPS will short treasuries, but they're still not going to make money when the bonds sell off, right? They're just going to not lose as much, right? So yes, it's been really a pleasure and a joy to innovate in the financial markets, take something that I think is very much in name only and access that other measure of inflation.

Yashi Yadav

Right. And while we're talking about inflation, and you mentioned the different risks that are still posed, what are your thoughts around the present state of inflation in the U.S.? Are there any specific areas of risk that you can point to there?

Nancy Davis

Oh, my god, there's so much on that. I mean, if you look at financial markets, you'd be like there's no risk, right? Because credit spreads are near all-time tight. I know you majored in credit, right, at Rutgers.

It's kind of cool. I didn't know there was a credit major. But yes, credit spreads, they can only go to 0, right? So if you look at some of the credit indices out there, especially short duration credit, it's crazy tight, right?

Like we just pull up the investment-grade credit index. If you look at like the 3-year credit index, CDX market on that, it's currently so, so tight that it can only go to 0. You're taking spread risk on top of treasuries, and it's just -- I don't think people are getting paid for that. So there are a lot of risks out there, but they're not really in pricing, right? Everybody is sort of like everything is good, soft landing, like don't worry about the treasury refinancing debt. Don't worry about the fiscal spending. Don't worry about, hey, even things like the U.S. election.

Yashi Yadav

Why do you think that is? I mean that's something that -- I mean, I also look at it a lot just from the retail consumer or investor where they just don't seem to have a lot of fear around the markets right now. Everything seems not -- it doesn't seem as chaotic -- I guess, as chaotic as one might have thought it would get.

Nancy Davis

Yes, for sure. I mean if you close your eyes and you say, okay, here we are in like take 2022, right? Everything was awful in '22, right? Inflation was running really hot. All asset classes were going down.

People are losing money in stocks, bonds, everything, right, maybe with the exception of real estate, which was going on probably with pandemic related labor market shortage issues. But everybody was really negative in '22 for the most part. Then if you just close your eyes, '22 sentiment was so terrible, and now we've had the Fed hike interest rates to 5.25%, right, and in about a 12-month period. Like would you expect markets to be higher or lower, right? I think the majority of people would have been said lower, not higher.

Yashi Yadav

Yes. Absolutely.

Nancy Davis

It's like opposite day right now because there is a lot of euphoria in markets, kind of everything has gone up in '23. We had a huge rally in both the bond and stock market into the end of -- the end of the year.

And then this year has been pretty strong, and everybody is sort of expecting a, the Fed to be cutting rates, be inflation to be cooling. And like everything is awesome, right? It's like the movie.

It's actually a great time to be positioning to own inflation in your portfolio because everyone is so complacent that inflation is not going to be a problem. And the Fed seems pretty set on starting the rate cutting cycle and you kind of have to wonder like is it really not an issue? Like I don't know. I mean look around, like I feel like every day I see inflation in my day-to-day life. It's definitely something that's pretty sticky and can be quite cultural as well.

Yashi Yadav

And I mean, on that topic, with the anticipation of the rate cuts coming, what are your like thoughts on how that will influence portfolios? And do you think that the credit markets have weathered the storm?

Nancy Davis

Well, credit spreads are extremely tight. So you just -- you have to understand that when you take a bond, whether it's investment-grade, high-yield, levered loans, floating rate debt, preferred, private credit, even everything in that space is taking corporate credit risk, which is a very similar beta to equity risk, right, because it's all corporates.

And so I think it's just really important that people don't go on strategy name only because you could have, say, short duration. Oh, I own short duration. I'm good, right? But it kind of depends what's inside of it because it has a lot of leverage or mortgages or credit, that's not maybe as risk-free as people like to think.

So I think for me, I think inflation is one of those things that a lot of people are kind of seeing as a trade. Like I feel like a lot of people are speculating, oh, inflation is going higher, it's going lower. And to me, I like to say I love -- did you see the Barbie movie, by the way?

Yashi Yadav

I did see the Barbie movie.

Nancy Davis

It was fabulous. Well, I'd like to say it's a big smile that like we live in a real world, this is not Barbie world. And it doesn't really matter what industry you're in or what you do, but everybody has a limited amount of savings, right, and income, and I think especially as you get closer to retirement, you might not have that income, but you still have a cost of living.

So I feel like everybody should have some exposure to inflation and they're in a well-balanced financial portfolio, and it's not really a trade to me. To me, it's more of just like something people should own.

And then the other interesting thing with indexing. Indexing has been wonderful and gives access to so many markets, but a lot of the fixed income indices are weighted based on market cap, right? So things like the Agg index, it used to be called the Lehman Agg and then it was the Barclays Agg and now it's called the Bloomberg Agg, but it's a super old index, and it has no inflation protected bonds inside of it, like 0. And about 1/3 of it, you can say, oh, it's core fixed income. It's just old and TIPS are new.

And then also any time that you have mortgages in your bond portfolio, if you think about it, like homeowners are -- want the option to prepay. If you own the financial mortgage, you're actually short options to homeowners and whenever you're short options, you're short-vol.

So I think a lot of people don't really realize that they have this embedded short volatility in their bond portfolio, and it's not VIX, right? It's not equity vol, it's actually fixed income vol. And so that's another one of the solutions that we wanted to provide with our funds was giving access to long fixed income volatility because everybody, for the most part, is already naturally short-vol.

Yashi Yadav

Can you -- could you explain that a bit more? So when you say giving access to the long fixed income volatility, like how exactly are you able to do that for individuals?

Nancy Davis

Yes. So we have ETFs. So there anyone, whether it's an institution or anyone their 1940 Act funds, sort of like, I'd say, the newer mutual funds, right, they're not mutual funds or exchange traded funds, but it's just a co-mingled fund that invest. So it's just like the rates market is something that a lot of people just don't think about, right? They have stocks and then they have bonds and their financial portfolio, but a huge amount of exposure in the U.S. market is actually interest rates, and that market's hard for a lot of people to invest in, even institutional investors. And so we actually have the ability to access the rates market, which is really unique. It's a huge market. It's one of the biggest markets in the world, and it's also very important because a lot of people have -- because of the passive indexing and kind of the move to systematic strategies, a lot of people have that huge exposure to short volatility because so much of the index is now mortgages.

Like we heard today that, it's March 20, the Fed just had their monthly -- the press conference today, and Powell is talking about the mortgage exposure on the balance sheet, right? They don't intend to hold mortgages on their balance sheet long term, but most individuals hold mortgages. And the mortgage market prior to -- if you go back, way back, like before the savings and loan crisis, it was all an OTC market, right? People didn't own mortgages in their portfolio. They had to be [ queue set ] and then they became tickers and then they were being able to added -- add them to indices and companies like ours could put them into indices. And we did that with the rates market, but instead of being short options, were long options. So whenever you're long options, you're long volatility. It's not equity vol, it's fixed income vol, but that, I think, is a really important thing to have as part of a balanced portfolio.

Yashi Yadav

So I guess what I'm curious about, Nancy is when you first launched the fund and were able to give access to this new and innovative part of the market, what kind of pushback did you face? Or did you face any at all? Or are people excited to be kind of putting the dollars into something new?

Nancy Davis

Well, definitely, we did get -- you have to have a lot of thick skin when you're starting a firm and you're doing something new because you do have a lot of people who kind of pushback and are not open-minded and want to do the same old thing and just play it safe and have the same benchmarks. But I think the nice thing is there are so many very thoughtful investors out there who are truly fiduciaries. And when they saw what we had done, they really embraced it, right? Not everybody embraced it, but that's kind of what makes the market. And so we did have a lot of, I'd say, early success with institutional investors who were like, oh, yes, this is amazing.

Also a lot of even RIAs who -- because ETFs are kind of tricky because you have to get approved on platforms before the wealth management people can buy them. And a lot of that is very, very much driven towards the larger firms, right? I think that's one of the things I'm pretty focused on is having more innovative strategies that some of these other firms that kind of don't allow smaller ETFs on, they just want the big ones, which are doesn't allow for a lot of innovation. But definitely I feel like we had a lot more success than people saying no, but we're still not approved on a lot of these kind of traditional wealth management platforms. And I sort of feel like their loss, right? That's unfortunate because people at those firms should be able to buy.

Yashi Yadav

No, I definitely agree with you. So are there any -- we've talked about the opportunity that you found and you were able to make available. And on the flip side of that, given your experience with the markets historically and what you've observed and looking at just the markets today and investor behavior, are there areas of risk that seem obvious to you that investors are not concerned about or ignoring? I mean I know we talked a little bit about the short-duration investment-grade bonds, but we could either sort of continue on that or any other areas that you can think of.

Nancy Davis

Yes. I think the big risk is defense balance sheet with holding mortgages and mortgages are such a large percent of probably regular investor portfolios. And then there's no -- a lot of the institutional portfolios also they don't have any inflation protected bonds inside of them because they create tracking risk to the Agg index. So I think the lack of inflation protection out there inside of portfolios and also the high concentration of short volatility products is kind of, I think, the 2 other concerns that I have in addition to kind of credit generally being very tight. And so the risk reward is not particularly compelling.

Yashi Yadav

Right. Going back to Quadratic Capital. You've come a long way. It's been over a decade now 11 years. What are your aspirations going into the future for the firm?

Nancy Davis

Well, I'm really focused on getting the manager research to cover the fund. We are an active ETF and a lot of that has been sort of a [ gate ], I would say, where you don't get coverage by like Morningstar, right? I really am hopeful that at some point, Morningstar will cover us even though we're a smaller firm and not just look at the strategy and then we can -- once we have research coverage, then we can be put on other platforms like certain platforms where the fund is banned, right? It's not allowed because it's not approved yet. So it's a little tricky being an actively managed ETF. I think a lot of the people in the ETF world think of passive funds and benchmarking, we don't really do that because there is an index for the market that we're accessing. So I'm hopeful that we'll get some more attention from being really a differentiated strategy.

And I think the other thing is that inflation expectations are so complacent now. Everybody thinks the Fed is going to be cutting rate, and inflation is not a problem anymore and it's priced that way, right? It's just like -- it's the same thing with stocks, right? When a company announces earnings, nobody looks at what did they do before, it's all about guidance and what do they expect in the future. And the same principle implies for all markets. And right now, the inflation markets are really complacent. The yield curve is massively inverted.

Volatility has fallen substantially from where it was even a -- it's crazy to think here we are in March '24. March '23, we had Silicon Valley Bank, and it was looking like we might have another banking crisis. And now it's like everything is everything is awesome. Everybody is expecting the Fed to cut rates. And look, what if they do cut rates and the indices and the measures that they have for measuring inflation are not right, right? It's all calculated by the Bureau of Labor Statistics, and they keep revising everything. So -- and we don't even know if that's the right way to calculate inflation because so much of the CPI is what they call shelter, which is actually the owner occupied rent and that might not be kind of relevant for a large group of investors.

Yashi Yadav

Yes. I know it feels like whiplash a lot of the time because you're on the brink of a crisis one day, then you turn around and it just feels like -- it almost feels like it was a decade ago, even though it wasn't. Yes, we've become a very reactive move on society somehow. But -- all right, well, to close things off, Nancy, what is one thing that you are looking forward to in 2024? Doesn't need to be market -- it can be, it could be markets related, but anything that comes to you top of mind.

Nancy Davis

I'm definitely excited about 2024. I think there are so many -- so many attractive opportunities out there. I think when you look globally, the Bank of Japan has now ended their negative interest rate policy, yield curve control is over. And so I'm really excited about kind of -- the normalization of the yield curve is really what we're trying to achieve with the IVOL ETF and the yield curve in the U.S. is massively inverted. Like even Japan has a positively slip yield curve and ours is massively negative. So I kind of feel like just a more normal environment is going to be fabulous. I look forward to kind of -- obviously, if we have any sort of surprises like the Fed has to cut rates quickly or even if the Fed does more of a higher for longer, there are a lot of different ways to make that play out. And so I'm really, really excited about that. And I think 2024 is going to be a great year.

Yashi Yadav

Amazing. All right. Well, thank you so much, Nancy, for joining us on Masters of Risk. This was a really insightful conversation. It was great to kind of hear about your experiences and hear about the firm and just everything you've accomplished in the direction that you all are heading. So I'm excited to see what's to come.

Nancy Davis

Thank you so much for having me as a guest on your podcast and really hope that this is inspiring to at least one person out there and...

Yashi Yadav

Inspired me, there you go.

Nancy Davis

That's awesome. Well, thank you so much again. I really enjoyed the discussion and, yes, here's to 2024.

Yashi Yadav

Perfect.

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