Mark Mehtonen is a Portfolio Manager, Tactical Allocation/Ilmarinen Alpha, at Ilmarinen Mutual Pension Insurance Co. in Finland. He spoke to Managing Editor Rob McGlinchey prior to the beginning of the Chicago Board Options Exchange’s Risk Management Conference Europe, at the Penha Longa Resort in Sintra, Portugal. Topics discussed in the interview included the pension fund’s use of volatility strategies and current opportunities in the European equity derivatives market.
Derivatives Week: What types of derivatives (asset class) does Ilmarinen Mutual Pension Insurance Co. use in its portfolio and for what purpose?
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Mark Mehtonen: We can use derivatives for hedging cash positions, for allocation in certain markets, and for absolute return purposes. In credit, we don’t use the exotic or squared type instruments, but for everything else we have structured credit guys looking at that area. So, I would say we use most credit related instruments, which is for generating alpha as well for allocating risk. In fx, we use all instruments across developed and emerging markets. We don’t do exotic options at all—we don’t do the kind of contingent payoffs that you see in the market. We use interest rates derivatives for alpha generation and we also use commodity derivatives. We have very few restrictions when it comes to underlyings or structures—contingency is one across all asset classes and then we have a few others, but there are not a lot of limits. For contingency, our systems don’t trade it or like it. Even without systems, contingency options usually have too much juice in them to be efficient. This is not always the case, but is more than often.
DW: What types of volatility strategies do you use and why?
MM: For absolute return purposes, we look at curve trading, calendars, market variance spreads, outright variance, delta-hedged volatility strategies, basically anything that we feel we can extract good risk premium from. So, as discussed, we don’t have many restrictions. What we actually do is to try and find discrepancies in pricing and inefficiencies in the market. We don’t continuously overwrite calls or stock baskets—that is not what we do on the alpha side. We try to find a way to capture absolute return typically with some sort of convexity position and so on. They are the fundamental approaches to where there is a good risk premium in different markets and maturities—typically this is in the further dated maturities. In equity, I don’t want to be competing with hedge funds in the very short-term buckets. So let’s say there is a curve discrepancy because of flows or whatever, then we can be there and counter it and take on the risk.
DW: Within your volatility strategies, do you trade the VIX regularly?
MM: No. We do trade it, but not a lot, as it doesn’t fit our approach too well. The liquid maturities are not within our normal operating range and the option strategies that are usually used are too expensive to execute.
DW: What is your opinion of the Vstoxx—is it liquid enough yet for you to begin using the index as a hedge or to generate alpha?
The Vstoxx market is not transparent enough for us to do any sizeable business in it. The risks are, I think, poorly understood by a lot of investors trading it. The spreads in the Vstoxx options are wide and it’s costly to trade. What’s driving the VIX market is, what you typically see and guess at, is that it is driven by the retail investors being comfortable with it and a bigger audience trading it, through ETFs for example. My guess is that this is not happening at the moment in the Vstoxx.
DW: Looking at the equity derivatives market in Europe, where do you see opportunities and in what sectors?
MM: I still see that there is potential upside in sectors such as financials and materials. I think Europe in general has a fair chance at getting bid through flows and possibly in economic conditions. Also, there is a catch up play against the U.S., but it’s not my biggest conviction to play Europe vs. U.S. as a spread play.
DW: We have seen a lot of flows into Europe, with the Eurostoxx Banks Index seeing increased interest. What is driving increased volumes in this index from your view?
MM: It is based on quite low valuations—it started from a low level and it is becoming a high beta play for a European recovery. It has come up from just below 100 to 130, but I think there is easily room for a lot more in that space. From a volatility perspective, the implied has been quite cheap so it’s not a bad way to play the index through options.
DW: From a volatility perspective, what is your view of opportunities in playing outperformance in Europe?
MM: Since a lot of vols have got depressed, it means you can find some good strategies where you can sell the more general Eurostoxx index against buying some of the more periphery indices. If you are able to capture some variance, you then can get some nice convexity positions. If you consider European tail events, then these kinds of periphery indices are going to react more aggressively. Therefore, you have volatility opportunities given that everything has been priced down to such a low level. But, if we have problems in the region, the spreads between these volatilities and especially in variance swaps is probably going to be much wider than what they are now.
DW: What do you look for in a counterparty that offers volatility strategies?
MM: We look for efficiency, transparency, a good track record and good pricing.