MLC Head of Derivatives, Cliff Bayne, speaks to MLC Research Manager, Rebecca Collins, about the design, implementation and oversight of risk mitigation strategies across MLC funds using a range of exchange traded and OTC derivative products.
Rebecca Collins: Hi and welcome. I’m Rebecca Collins, Research Manager for MLC and today I’m joined by Head of Derivatives, Cliff Bayne. Thanks for your time today Cliff.
Cliff Bayne: Hi Rebecca, thank you very much for having me.
Rebecca Collins: When we talk about derivatives, it’s quite a big universe. Can you talk us through some of the derivatives MLC use, in client portfolios?
Cliff Bayne: Some of the more basic ones that we use would be things like futures, swaps, options. By way of an example a future, it’s very similar to a stock in that it’s a linear payoff profile. The difference between that and say a stock is purely that you don’t need to put up all of the cash, to invest in the future. So you need a margin.
Rebecca Collins: So that’s one of the benefits of using a future.
Cliff Bayne: That’s one of the benefits, yes.
Rebecca Collins: There are some other benefits of using futures in portfolios?
Cliff Bayne: It’s quite a liquid instrument. Also, if you look at index futures, you're covering the entire market with one contract. That can be very advantageous from a cost efficiency perspective. Other things are things like options, which are very much like insurance and they allow us to protect the portfolio, particularly with the downside protection that you can purchase. Those require a premium, just like you would on your house insurance, for a specific outcome.
And then the other things would be things like swaps. For example, when you take out a mortgage, invariably you have a variable mortgage. And then when interest rates get low, you want to fix that, you want to go into a fixed mortgage. That transfer, or the variable mortgage to a fixed mortgage is a swap. We do similar things, but we do it across all sorts of different markets. And ultimately, you can swap any set of financial outcomes for any other set of financial outcomes.
Rebecca Collins: So that all sounds really positive. So what are some of the things we need to consider before we use derivatives in a portfolio?
Cliff Bayne: There’s actually quite a large myriad of things that we need to consider. The first is that the strategies that we’re formulating actually conform with the objectives of the portfolio, and meet the portfolio manager’s requirements. The other things are things like liquidity; we need to know that we can get into and out of these positions in an efficient way. We have to consider all the different potential market moves and what the impacts are to those derivative contracts.
And then we have to go into things like legal and regulatory requirements, making sure that we can adhere to all of those, which can be quite extensive, particularly if you go into the global markets. And finally, some derivative contracts are what we call over the counter. Which means that we’re dealing directly with another counterparty and we need to make sure that they’re creditworthy. So that we know that, if those contracts are in the money for us, we’re going to get that money.
Rebecca Collins: So how does MLC manage some of these risks for our clients in our portfolios?
Cliff Bayne: The first thing to start with for these strategies is that the portfolio manager will come to us with their specific requirements and their objectives. We formulate those strategies on those requirements. And that’s our responsibility, to come up with solutions that will meet the requirements. And then the portfolio managers also have to take responsibility themselves, for things like the costs and the monetary outcomes, or potential monetary outcomes. Making sure that they’re aligned to their portfolios. Having formulated all of that, that will all get documented and it will ultimately go to the investment committee. And the investment committee has to sign off on all of our strategies, making sure that they are aligned to investors’ interests.
Rebecca Collins: Can you talk me through an example of a derivative that MLC’s currently using in the portfolio, or has used this year, for some of our clients?
Cliff Bayne: Earlier this year, we needed an emerging markets equity exposure, in the portfolios. It was quite hard to find a manager that wasn’t too expensive in that space. The portfolio managers came to us and we actually provided them with a solution, around using futures on the emerging markets index. So we were able to capture all of that emerging markets exposure. And invest the managers’ money into that market.
It was quite opportunistic in that we were then presented with a new opportunity, from one of our counterparts to allow us to switch some of that emerging markets exposure, directly into China. We transferred a small allocation into a very attractive swap, into China. And that opportunity was so attractive; it actually allowed us to consider some of the risks around China. Compared to the emerging markets, it is a much riskier environment and much more volatile. And so we were actually able to use the benefits that were given by our counterparty, to purchase option protection for free effectively.
And so we protected the portfolios. China and emerging markets did go down the latter half of last year, but we were able to suppress those falls. And then subsequently, we’ve had a very very strong rally, which we’ve been able to participate in, particularly with China.
Rebecca Collins: So derivatives can provide a really efficient liquid market exposure when the situation is managed carefully.
Cliff Bayne: Absolutely.
Rebecca Collins: Thanks for your time today Cliff and thank you for joining us.
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