A CIO who predicted the madness that rocked markets in late 2018 says there's more turbulence coming this year. Here's how she thinks traders can take advantage.

Nancy Davis of Quadratic Capital Management says that's not a bad thing if traders and investors are positioned correctly.
Traders can hedge against volatility and make money by being long fixed-income volatility, she said, using Quadratic's IVOL ETF as an example.
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Some experts think there could be more turbulence ahead in fixed-income and equity markets through the end of 2019. But that doesn't scare Nancy Davis, managing partner and chief investment officer of Quadratic Capital Management.

"I think the end of the year always has a greater potential to have more volatility," Davis told Markets Insider in an interview. "And I think there's also a lot of subsurface currents going on right now that are not healthy indicators."

Equity markets have whiplashed through 2019 on trade news , the Federal Reserve's policy , and recession fears . Fixed income has also been choppy this year. US Treasurys rallied until September, but have bounced since. The increased turbulence is reminiscent of the end of 2018 , when volatility spurred by US-China trade negotiations rocked the fourth quarter and pushed the bull market into the red.

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While volatility may ramp up in 2019, it's not something that investors need to be worried about if they're positioned correctly, Davis said. She called the similar blowup of late 2018 in a July interview with CNBC.

"Long term, you want to own things that are not going to be correlated to everything else," she said. "If the risk in one's portfolio is that equities fall, credit spreads widen and volatility increases, being long fixed-income volatility is a good way to be defensive and protect equities in the portfolio."

For Davis, being long fixed-income volatility and hedging against inflation are key. Davis runs an ETF positioned to do just that the Quadratic Interest Rate Volatility and Inflation Hedge ETF, or IVOL, was launched in May. The fund currently has $67.34 million assets under management, according to ETF.com .

Many kinds of volatility

Most investors' view of volatility in the market is narrow, Davis said. This means that they might be leaving opportunities to gain on the table.

"A lot of people think volatility and they think of the VIX," she said. But the VIX, or the Cboe Volatility Index, is only one type of volatility, and a "tiny fraction of the volatility markets in the universe," she said.

Fixed-income markets are much larger, specifically interest rate volatility markets, she said. IVOL trades volatility only accessible via the over-the-counter options market, which are the result of a private transaction between buyer and seller. It also trades Treasury inflation-protected securities, or TIPS.

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Right now, she sees her ETF as a solid value investment because compared to other assets it's incredibly cheap. And, it's distributed roughly 30 basis points each month, she said, which is about double the 13 basis points that the 10-year US Treasury bond is currently distributing.

It also gives investors access to something most people can't get on their own, as OTC options don't trade on a formal exchange. In this way, the ETF is democratizing financial markets, said Davis.

Active is better

For trading fixed income volatility, active management is better, Davis said. This is because there isn't a lot of long volatility baked into passive benchmarks for fixed income the primary benchmark is the Bloomberg Barclays US Aggregate Bond Index, which is 26% mortgages, Davis said.

"Mortgages are inherently short fixed income volatility," she said. This is because the owner of a home can prepay the mortgage anytime, adding prepayment risks and meaning that the owner of the mortgage is essentially short the option to the homeowner.

"I don't think people realize that they're actually short fixed income volatility in that index," she said, stating that there is a lot of money chasing the benchmark.

But the benchmark isn't positioned to do well if volatility ticks up, she said. This means that investors could feel pain through the end of the year if markets whipsaw further.

If volatility increases, investors pegged to the Bloomberg Barclays index will lose money. But investors that are long fixed income volatility, like those in her ETF, will gain, she said.

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