Episode 39

FEBRUARY 23, 2022

Brett Pacific on defensive risk premia

Brett Pacific, Senior Managing Director, Head of Derivative & Quantitative Strategies at SLC Management, discusses how inflation and the current high risk environment can affect managing portfolio risk at the macro level.

Steve Peacher: Hi everybody, this is Steve Peacher President of SLC Management, and thanks for dialing in to this “Three in Five” podcast. Today I’m with Brett Pacific who is a senior managing director and head of SLC’s derivative and quantitative strategies. Brett's been with the SLC and Sun Life for a lot of years. Brett thanks for taking a few minutes.

Brett Pacific: Hey Steve thanks for having me, glad to be here.

Steve Peacher: So I want to talk about something that I find really interesting that you and your team developed and it's a product that we run for some of our clients, we call DRP or defensive risk premia. And before we jump into that specific product, could you talk about these types of strategies in general, and what institutional clients are trying to achieve when they invest in a strategy like our DRP strategy?

Brett Pacific: Yeah, absolutely Steve. So the genesis of DRP in this broader category of these overlay strategies really has to do with managing portfolio risk at the macro level. Given that more and more portfolio managers think about risk in terms of factors and how they interact within the portfolio, we were looking for opportunity to add a strategy that we overlay, offer clients that would help kind of manage risk in particular tail risk. A lot of clients coming out of the financial crisis realize that the risk in their portfolios wasn't really stationary and that you know during times of economic stress they would really see risk bubbling up from different parts of their portfolio that they really didn't recognize in the past. So, for us, you know after the crisis we really rolled up our sleeves are started thinking about that, thinking about tail risk in shaping the distribution of risk in portfolios and that's how we came about thinking about okay, how does volatility play out during times of good times and times of stress, and can we think of strategies or instruments that we could embed within our portfolios to help pay off.

Steve Peacher: And I know that there are a number of different ways that different asset managers approach this problem, and they use different types of models, etc., and we have our own unique models. So, can you talk a bit about how we approach it, how does our model work? And Brett don't give up don't give away the secret sauce.

Brett Pacific: I’ll do my best not to not to do that. So for us we're looking for a rebalancing mechanism within our portfolios, something that we could add to the portfolio during times of stress to help manage the overall portfolio volatility and risk. Generally, a lot of other portfolio managers will look think about, okay, what type of assets have low volatility, or maybe negative correlation during times of stress. And a lot of times you think about the U.S. Treasury market. Well, why? Because the U.S. dollar is the reserve currency in the world, during times economic stress people look for liquidity and they look for U.S. treasuries. And we agree with that logic and so, for us we thought okay let's try to embed more our treasury risk within our portfolios, but how can we do that in an optimal way. So, again we really rolled up our sleeves and started thinking about how does risk evolve during risk off events. And what we really thought about were two things: where it was this flight to quality mechanism in the marketplace where portfolio managers are de-risking their portfolios. You know they're selling risky assets, they're buying less risk assets, you know they’re selling, generally they’re selling equities and buying they’re U.S. treasuries and we thought to how we do that, coupled with there’s the liquidity risk premium as well. When you think about it during times of stress people searching for liquidity their portfolios, that were trying to sell things that are fairly liquid and try to get into cash, and so our model and our research is based upon those two those two things, and so we looked to be able to monitor and examine volatility in different parts of the market and when we see volatility bubbling up and then we'll move into less risk assets. For us our risk less asset is the U.S. Treasury futures. So our strategy is during times of stress, we will add treasury futures to our portfolio as rebalancing mechanism for the overall risk portfolio. And the way we do this is we look at a basket of indicators that we think is a good representation of the volatility across the capital markets. So we'll look at things such as equity volatility in the U.S. and in Europe or we'll look at maybe credit spreads maybe high yield or our investment grade. Even commodities, we’ll to look at maybe oil volatility and currencies and we’ll look for changes in the volatility profile of these indices. And when we see enough stress in these industries, then our models pay attention and think this could potentially be a risk off environment.

Steve Peacher: This has been an interesting period since the beginning of the year, we've had very high inflation readings, due I think largely to supply chain issues around the world. We've had you know we're in seems like we're entering a period of rising rates. The 10-year treasuries pushed up above over 2% and is up about 50 basis points year to date1, the S&P has been volatile and is down 7% or so year-to-date2. And I know these models should be evaluated and judged over long periods of time, but in this short period, year-to-date period this last month and a half, what is our what is our model shown, what have we done as a result of the signals giving off?

Brett Pacific: Yeah, it’s a couple things: one clearly, we're in a higher risk state environment than we were in the past. We're seeing that in a number of markets, certainly equities, we’re starting to see it more in commodities obviously, even currencies, different currencies, starting to see higher volatility there. So, we feel we're in a higher risk state environment absolutely, but what our model is telling us is is that the rebalancing mechanism of that flight to quality into Treasuries really isn't there. The way we think about this is inflation. What's the inflation threat in the current environment? If so, is it high enough, then maybe the rebalancing mechanism shouldn't be U.S. Treasuries, so in our strategy, we have an inflation filter that looks for stress, looks for inflation in markets, doesn't necessarily monitor inflation but things that are impacted by inflation. And what our model’s been telling us since the beginning the year that the markets are very concerned about inflation. And we're seeing that not just here in the U.S. and Canada, we're also seeing it Europe and Asia, and so our models have actually a bit off even though we've been in this high volatile market environment because of the inflation of fear that we've seen since being January.

Steve Peacher: Interesting well, of course you and I have talked about this model a lot, it's fascinating and we could spend an hour talking about this, but we are going to try to keep this to the five minutes that we try to with these, but it's a fascinating topic. Let me end by asking you a question that has nothing to do with this DRP product, and that is I know that you, like a lot of people these days, like podcasts and listen to a lot of different podcasts. Any recommendations for our listeners in terms of a podcast or two that you particularly find interesting?

Brett Pacific: Oh, Steve that's a good question. You are correct, I do like podcasts. One that I’ve been really focusing on recently is produced by the BBC Radio, it's called “In our time history,” and what's really interesting is each week they produce a new segment on different periods of time that are interesting to the people in the UK. And so they might say way back in time, think about from the very beginning about maybe literature and Gilgamesh and how that book impacted future writers over time. Or maybe it's very local, about the 30 Year War and how they impacted our current political thinking in UK. I find that all really fascinating, it's a bit geeky but very interesting.

Steve Peacher: Well, I have listened to one of those episodes, I agree with you there they're pretty fascinating, so I have to clue into more of those. So Brett thanks for taking the time, thanks for giving us a glimpse into this DRP product and also for the podcast recommendation.

Brett Pacific: Thank you Steve.

Steve Peacher: And thanks everybody for listening to this episode of “Three in Five.”


1 https://www.cnbc.com/2022/02/10/us-bonds-treasury-yields-climb-ahead-of-inflation-data.html

2 https://www.reuters.com/business/futures-fall-rate-hike-worries-eclipse-strong-apple-results-2022-01-28/


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