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Delivering Alpha

Manager who predicted the blowup of the low volatility trade says markets to remain turbulent for some time

Key Points
  • Quadratic's Nancy Davis, who predicted that the popular low volatility trade would implode, says the market will remain turbulent for some time.
  • Davis told CNBC in October that so many investors were short volatility that a mild uptick in market uncertainty could lead to an exaggerated spike in volatility.
  • Since then volatility has skyrocketed as fears of an overheating economy sent stocks tumbling.
Chief investment officer breaks down how to trade volatility

Quadratic Capital Management's Nancy Davis — who correctly predicted the blow-up in the popular wager on low volatility by hedge funds before last week's plunge — thinks the market will remain turbulent.

"It's created a very large exposure of short volatility, and I think it's created a huge opportunity for actually owning volatility," said Davis, Quadratic's managing partner and chief investment officer. "The market's not settled down, we're not in smooth sailing anymore. People are still in the buy-the-dip mentality."

The options advisor added that, instead of exposure to equities and bonds, investors may want to take a second look at inflation plays.

"Return expectations, in my opinion, are still wildly too high for equities and bonds, but other asset classes linked to inflation are actually very attractively priced, like agriculture commodities," she added. "We like commodities quite a bit."

Davis, who spoke with CNBC at the Sohn Conference in October, then warned that so many investors were shorting Cboe's Volatility index (VIX) that a mild uptick in market uncertainty could lead to an exaggerated spike in volatility.

Quadratic Capital is based in Greenwich, Connecticut, and is majority owned by women. The advisory firm primarily uses derivatives to invest in its global macro strategies.

"I think a very common theme — and it's kind of the best sharp trade out there — has been selling volatility. The problem is everyone is doing it now," said Davis in October. "I like to say the 'big short' out there is people who are short vol. Now that doesn't mean that vol is going to spike hugely at any point, but it has the possibility to because so many investors are short volatility."

On the day Davis spoke with CNBC in October, the VIX closed at an all-time low of 9.19. Since then, however, volatility has skyrocketed as fears of an overheating economy sent both the Dow Jones industrial average and the S&P 500 tumbling more than 10 percent in early February.

At the latest reading, the VIX was at 26, down from highs over 50 last week.

While worrisome, the fall in the major stock indexes was dwarfed by the rapid depreciation in assets short volatility.

Exchange-traded products VelocityShares Daily Inverse VIX Short-Term note (XIV) — which Davis had sold short — have effectively lost all value, with the XIV falling more than 95 percent over the past eight days.

— CNBC's Leslie Picker contributed to this report.

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