ETF hedging interest-rate risk comes out of the gate with 67% gain this year

With downward pressure continuing to spread across the financial markets, at least one strategy is giving investors hope by betting on and benefitting from the trend toward higher interest rates. The Simplify Interest Rate Hedge ETF (PFIX) has streamlined a relatively sophisticated institutional investing strategy to generate a 67% return so far this year.

Launched 12 months ago by Simplify Asset Management, the $267 million fund is still operating below the radar screen of most financial advisers. But that isn’t likely to be the case for long, especially if the performance continues to generate returns in such stark contrast to the broad market indexes.

Stubborn inflation coupled with an economic slowdown, rising interest rates and the threat of a looming recession have combined to drive the S&P 500 Index down more than 16% this year, which looks good next to the 26% drop by the Nasdaq over the same period.

Meanwhile, PFIX is moving in the opposite direction with a portfolio that blends five-year Treasury notes with seven-year put options on the interest rate on the 20-year Treasury.

“It’s a hedged bet that the [price of the] Treasury is going down as yields go up,” said Simplify managing partner Harley Bassman.

“It’s a simple way for an ordinary civilian to protect against higher interest rates,” Bassman said. “It’s a pure way to express the risk of long-term rates going higher. It’s almost like buying a futures contract.”

The allocation within the static portfolio, which has an expense ratio of just 50 basis points, is determined by the cost of the put options, which are determined by market volatility.

For example, a year ago at the fund’s launch price of $50 per share, $25 went toward buying the five-year Treasury bonds, and $25 went toward the put options.

But in May 2021, the 20-year Treasury on which the put option prices are based was yielding 2%. That yield has since spiked to 3%, which means the cost of put options currently represent about two-thirds of the fund’s share price, which is now around $63.

Bassman said the reason more asset managers aren’t rolling out similar strategies is because the strategy involves squaring off against institutional traders in the over-the-counter options market.

“To get an option that expires in seven years you have to go to the professional OTC market,” he said.

Simplify, a $1.4 billion asset management firm, has trading agreements with Morgan Stanley, Merrill Lynch, Goldman Sachs and Barclays.

For a sense of the dynamic nature of the strategy, note that there are currently about 3 billion options in the fund. The fund, which was launched with $5 million, traded 400,000 shares on Friday, and has seen average daily trading volume of 200,000 shares over the past month.

“PFIX is a great example of the new tools advisers have available as an ETF,” said Todd Rosenbluth, head of research at ETF Trends. “To invest in long-dated put options on Treasuries directly would be much more challenging and likely harder to manage in a client account.”

While the fund is a bet on higher interest rates, the fuel behind the strategy is many of the same factors driving down the broad equity markets.

While the Federal Reserve is ramping up its aggressive tightening cycle for short-term interest rates, the rising rates on longer-term bonds is being driven by inflation, the economy and anticipated Fed policy, which is toward higher rates.

“It’s an insurance policy,” said Bassman, who explained the strategy in detail in a February paper entitled The Convexity Maven.

Describing it as “fire insurance, revisited,” Bassman models a $40 initial price of the portfolio across changes ranging from a 50-basis-point drop in interest rates to a 300-bp increase in rates.

If rates drop 50 bp, the $40 is worth $34.16. But a 100-bp increase means the value climbs to $63.40, and with a 300-bp change, the value climbs to $181.64.

Like any hedged strategy, the downside can cut deep. In this case, if interest rates reverse course, Bassman said the price of the options could go to zero, leaving the value of the short-term Treasury bond position.

“As you go higher in interest rates, each basis point change is worth more,” he said. “But the most you can lose is what you paid for the option.”

[More: Schwab starts hedging interest-rate risk with derivatives]

Related Topics: Federal Reserve