Episode 66

SEPTEMBER 28, 2022

Brett on why investors shouldn't be afraid of derivatives

September 28, 2022

Brett Pacific, Senior Managing Director, Head of Derivatives & Quantitative Strategies at SLC Management, discusses how derivatives can help institutional investors meet their goals.

Steve Peacher: Hi everybody. It's Steve Peacher, president of SLC Management. This is “Three in Five,” and today I've got Brett Pacific, who's senior managing director and head of derivatives and quantitative strategies at SLC Management. Brett, thank you for taking a few minutes.

Brett Pacific: Steve, glad to be here.

Steve Peacher: So Brett, you know we've worked together a long time. All things derivatives related, you and your team, and it can be a scary area for people who aren't familiar with it, and that can be even true for institutions, you know you can even see some institutional investors who get a little bit nervous when it comes to the thinking about derivatives. So maybe we can start by just having you give kind of a very high-level view of kind of what derivatives are and why do institutional investors use derivatives to position their portfolios?

Brett Pacific: I get this question, I’d say quite often, and I agree for some investors this might seem a bit scary, but we believe that they're an important tool in the toolbox, especially for LDI mandates. Big picture, derivatives are instruments that we use to shape risk within a portfolio without impacting the underlying asset allocation of the holdings. They're overlayed on top of the existing portfolios to help better manage a base amount of risk, but also enhancing a portfolio’s return profile, so we use overlay strategies to more efficiently manage client mandates. There are many stories of hedge funds running into trouble using derivatives, you know, looking back to long-term capital in the U.S. and other instances, and think “why would I need them?” Well, I would say in a well-defined, well-controlled framework, derivatives are a necessary tool for many clients. For instance, an underfunded pension plan in a low-rate environment, with low return expectations, has an uphill struggle. Without the use of derivatives some plans might be forced to increase risk or go down the quality spectrum to meet and investment targets. You know, we think of the benefits of derivatives in kind of three broad categories: risk reduction, yield enhancement, and also, you know, portfolio flexibility. Risk reduction between assets and liability benchmarks for LDI clients is an obvious benefit. Minimizing the gap between assets and liability benchmarks can help minimize funding volatility for pension plans. Also, they allow us to reduce overall volatility in an asset portfolio. They're a practical tool for shaping risks within the portfolio, and reducing tail risk. Derivatives can help cut off the tail of downside risk of owning risky assets. We also use derivative for yield enhancement without impacting the underlying physical portfolio. Since overlay strategies sit on top of the existing portfolio, we can overlay derivatives to pick up incremental yield. Generally, we're using liquid instruments that can add flexibility to a portfolio. They can allow for efficient portfolio rebalancing, and we can add incremental risk to each individual portfolio. For example, cash equitization, an equity future strategy, can reduce the drag of holding excess cash, which can give a PM’s greater flexibility in managing portfolios. So, these are just some of the benefits of using derivative overlays. But obviously there's many, many more.

Steve Peacher: So, you know I think people often associate the word ‘derivative’ with risk or adding risk. And what you're saying is you can actually use them to reduce risk in a portfolio which is interesting, and you mentioned some examples. Any other common examples or common ways that you know, you see clients specifically implementing derivative strategies?

Brett Pacific: I think we start by thinking about risk in kind of four broad categories: interest rates, equity, currency, and credit. In each of these categories there are opportunities to improve the risk return profile in individual portfolios. Interest rate strategies are kind of the 101 level. We can start here with what is probably the most common use of derivatives, which is shifting duration risk within a portfolio. Derivatives can help us to efficiently manage key-rate durations. For example, you can add duration of either interest rate swaps or bond futures. Interest rate swaps are an effective tool. They enable precise matching of liability benchmark durations, while bond futures are great for rebalancing duration, adding incremental risk to a portfolio. Again, these unfunded strategies allow us to manage duration while not impacting underlying physical block portfolio. Often a manager will want to own foreign assets to improve portfolio diversification. But many, many plan mandates will not tolerate FX risk. So, a common strategy that we use is to add a layer of currency overlays to hedge that FX risk. So, for example, a U.S. dollar private fixed income position can be hedged using cross-currency swaps to convert the U.S. dollar cash flows back to Canadian dollars and this eliminates the U.S. dollar FX risk as well as the U.S. interest rate at risk. So effectively we create a synthetic Canadian dollar fixed income asset using a cross-currency hedge. In equities we often think of risk management in terms of downside protection. You know, cutting off the tail. This can be simply done by buying equity index puts to reshape a portfolio and to cut off that left tail of the distribution.  I'd also probably mention, you know, derivatives can also be used for return enhancement by adding measured, well-defined risk to the portfolio, we can add beta and potentially alpha as well. So, a common strategy we use to pick up income is to layer credit risk via credit default swaps over TIPs or RRBs in Canada. This strategy is quite popular with clients that have inflation-like mandates. Again, all these strategies are designed to help shape risk and improve portfolio returns.

Steve Peacher: So, if a client decides that any one of those strategies to be implemented with derivatives might be useful in a portfolio, they might say that sounds great makes sense, and you you're obviously very used to describing these strategies a very straightforward and understandable way, but they might say, but isn't they going to add a lot of operational complexity? I might be posting collateral, or is pricing on these difficult? So, is this going to make just the day-to-day operations difficult when I put a derivative overlay onto my portfolio? So how do you address this for clients in terms of just handling the complexity that comes with derivatives from an operational standpoint?

Brett Pacific: Yes, Steve there definitely is a level of operational complexity when it comes to using overlays. Managing this operational risk or complexity starts really at the organizational structure. You know, firms shouldn't mix responsibilities within the firm, need to have clear separation of responsibilities between you back, your front, and your middle offices, and then you need strong oversight from senior management, from compliance and from risk management. I always think of a prominent example I always think about of poor oversight for derivatives comes to my mind. So, Barings Bank ran into trouble operational risk using derivatives in the Singapore office. This made headlines at the start of my career. So, this one really left an impression upon me over the years. So, the bank appointed someone to oversee both the front and back office for its derivatives business in Singapore. This person had oversight of trading as well as operations, and their trading strategy was to double down on derivative positions when they had losses. It's not a great risk management strategy. Now, this guy was able to hide trading losses into their account that he oversaw. He amassed a really sizable position in the Nikkei index options. This worked really well until he was cut out one day when the Kobe earthquake hit and equity markets, the Japanese markets is really tanked. His trading losses were at one point twice the trading capital for the entire bank globally, he effectively put the firm out of business. So, this this one really, you know, resonates with me. It hits home is, you know, a simple point: people trading shouldn't have access to operations into settlements. The clear separation of duties to help minimize all that operational risk when it comes to derivatives and other types of instruments that are fairly complex.

Steve Peacher: So, have controls. You're going to putting on derivative overlays make sure you've got all the right controls, like you would with any other financial instrument as well. Well, that's illuminating. You could, you know, you could, we're just scratching the surface of a really complex topic. But let me ask you, let me end with one question completely unrelated to derivatives. So, we're recording this in September, so it's after Labor Day. It's back to school time, but I think it actually feels a little bit different to me, anyway, because, there's no clear demarcation as to when kind of the era of Covid is over. Clearly, we're still living with it on an ongoing basis, but it feels to me a little bit more like everybody's kind of back. So, as you, as we move into the fall, which is a time of a lot of energy, change in the weather, what are you most looking forward to this fall?

Brett Pacific: Yeah. Well, I'm definitely happy the kids are back to school, and that's behind us, and in the fall coming into winter I'm really looking forward to the season. You know ski season in New England's coming up soon, really excited about that. We try to hit the slopes as early as possible. So, hopefully, you know, before Thanksgiving we're up there, really looking forward to some new snow.

Steve Peacher: Yeah, we used to. I remember back in the day we used to be the up there the weekend after Thanksgiving, and there was never a whole lot of snow, but you made due with what there was. But listen, Brett I really appreciate it. Thanks for taking the time, and thanks to everybody for listening to this episode of “Three in Five.”

Brett Pacific: Thank you.


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