Early Out and Early Back?

Lyxor Asset Management looks to have passed the nadir

Originally published in the July 2009 issue

On a recent trip to a European capital with a CTA client, a third-party marketer for hedge funds was told by seven potential investors visited out of eight that they would consider investing in the CTA only if they could do so through a managed account. It could be that the potential investors were making an excuse in specifying the use of a managed account so as to need not take their due diligence further, but more likely another message was being put across through a megaphone: after their experience of the last year, investors in hedge funds would prefer to access the investment strategies of their favoured managers through managed accounts. So it is timely that The Hedge Fund Journal met with Alain Dubois, the Chairman of the Société Générale Group subsidiary Lyxor Asset Management, the daddy of the managed fund business, to talk through changes in the business.

Lyxor enjoyed 10 years of uninterrupted growth from inception until last year. In 2008 the assets of the hedge fund industry have been estimated to have shrunk through redemptions and negative performance by a whopping 42%. The SociétéGénérale subsidiary was not immune to the fall in assets: in fact its superior liquidity – a key selling feature – meant the platform suffered disproportionately. But now, as the third-party marketer heard in Vienna, there are good reasons to think that the commercial case for managed accounts is stronger than ever.

Heightened appeal of managed accounts
The heightened appeal of managed accounts as a means of taking hedge fund exposure is a response to the recent problems experienced by the industry. The negative returns generated by 70% of hedge funds in 2008 have significantly challenged the rationale for investors being in hedge funds at all. Additionally, the past year has also thrown up problems in redemption and in the due diligence processes of intermediaries who channel capital into hedge funds. Alain Dubois has a response to these problems: “The business model of Lyxor aims to eliminate the main sources of risks investors are typically exposed to when investing directly in hedge funds. At the same time the performance rationale of alternative investment programmes can still be fulfilled.” So how does Lyxor achieve that?

lyxortable1The hedge fund platform of Lyxor comprises more than 100 hedge funds. These cover all the main investment strategies and represent a diversified investment universe combining a high level of transparency, risk control and liquidity. There are some very well known names among the managers on the platform. For example, John Paulson has been on the Lyxor platform since 1999.

Each hedge fund on the platform can be invested on a stand-alone basis through direct investments, as they are all Dublin-listed funds. “So they can be seen as a means to create efficient fund of hedge fund portfolios,” says Dubois, “while offering investors strong guarantees in terms of security.” This is partly achieved through limiting the specific risks generated by a lack of transparency. Transparency is a hot button at Lyxor: “Transparency is inscribed in the genetic code of our hedge fund platform,” enthuses the urbane Dubois. “This transparency is an integral component of our approach and dictates our willingness and ability to manage risks.”

This is the key commercial point for Lyxor. All managed accounts offer investors access to detailed and regular performance and risk reporting, but in addition Lyxor uses full transparency to secure the NAV calculation and to ensure the managers are doing what they are supposed to do risk-wise. Much of the time managed accounts are offered as an administrative capability by a bank in isolation.

Société Générale takes a wider perspective view, and hedge fund related activity has always tapped into the wider resources of the group. Its risk management and risk measurement capabilities track and monitor risk exposures of the subsidiaries but they are also a resource to all companies within the Société Générale Group.

“Risk management is at the heart of our business,” says Chairman Dubois. “Our independent risk department supervises risk during the entire lifecycle of a fund. Our experts define the appropriate fund management parameters – investment limits, procedural framework, methodology – and design monitoring tools enabling appropriate risk analysis.”

Lyxor ensures from the outset that it will only work with managers who utilise a style of investment and instrument universe that can be monitored effectively. This enables Lyxor to implement high-frequency risk reporting for internal purposes, and weekly valuations for investors’ dealing and tracking of their investments. So both Lyxor, as controller of the managed accounts, and external investors, who provide the capital, can watch more closely than is common for style drift by the hedge fund managers.

Alain Dubois explains: “As we are setting up a managed account we come to a written agreement with the fund manager that specifies the investment guidelines with which it will operate. In this mandate document we agree the type of investment strategy that the manager intends to follow; we lay down between us what instruments the manager can use. We ensure at this stage that the instruments are only those that we can price, and it can include over-the-counter contracts. It is the job of the administrator of the capital pool – managed account in this case – to price the assets. We use several administrators to produce the NAVs and process the capital flows for the managed accounts: EuroVL, IFS and GlobeOp. The complex derivatives or OTC instruments are modelled and priced by the administrator, and it is absolutely necessary that we know that the administrator can price the instruments before we take on a managed account for that manager. We supervise to a great extent the work of the administrator, because when it comes to pricing in particular you cannot leave the administrator completely on their own when there are uncertainties on pricing of instruments.”

Ultimately the fund NAVs have to be agreed by the board of the fund, or managed account, and Lyxor has legal control of the capital. In circumstances where there are discussions about the pricing necessary to produce the NAV, Lyxor may well get involved, though these discussions could well be internal within the administrator. Less common would be the circumstance of a debate going on between the manager and the administrator over fund valuations because of positions held – then too Lyxor is able to join in the discussion and provide a third-party price. “So the process of pricing of the fund or managed account is completely independent of the investment manager – this is really important,” states Dubois.

To come back to one of the industry problems, whilst the disciplined screening of managers may have helped avoid a Madoff–type event at Lyxor, a managed account platform would have made embezzlement of the capital, or fraudulent misrepresentation by a manager impossible by other means. First and crucially, the legal control of the title to the assets of the capital in a managed account on a platform always remains with the platform. So the assets are held beyond the control of the investment advisor, even though they can implement investment strategies with them.

Second, on a platform managed account assets are regularly risk assessed and independently priced as well as audited annually. In effect the platform can see the assets. In these points the framework of the platform and the additional resources brought to bear completely counter the abuses perpetrated by Madoff, who operated mostly through managed accounts independent of platforms rather than through funds.

Liquidity a strength and a weakness
Another strength of Lyxor as a managed account platform is that it provides investors with a large investment capacity and weekly liquidity. One of the commonly cited limitations of funds of hedge funds, though it does apply to all those who invest in hedge funds, is that it is not possible to move capital around between managers and strategies at short notice. So if market conditions suddenly favour a particular sub-style of investment strategy it can be difficult to capture that available additional return because hedge funds are typically a medium-term investment vehicle, with multi-month notice periods and sometimes only quarterly dealing days.

So for example, a sudden spate of M&A activity might point towards event driven strategies but how do you quickly get capital into funds that will benefit? This is where Lyxor’s platform gives a significant advantage to investment decision makers – investors can subscribe and redeem on a weekly basis, a very rare dealing flexibility in the hedge fund business. ”The ability to subscribe or redeem on a weekly basis can be seen as a very strong risk control for investors,” affirms Dubois.

However, though this enhanced liquidity is a strong advantage in a bullrun, when investors are jamming money into popular funds on positive flows to the industry, it worked against Lyxor’s managed account platform when industry level flows reversed last year.

“We lost assets early compared to the rest of the industry last year,” explains Alain Dubois. “We were in the position of being a cash machine, an ATM, for funds of funds and other investors as we were still open when single manager funds started to put up gates and limit redemptions. There were two sorts of redeemers – one more of a retail sort of client who became very afraid of alternatives, plus those seeking an increase in their cash levels across all of their investments.”

That facility to liquidate was heavily used – AUM on the platform went from US$12 billion at the peak early 2008 to US$5 billion at the end of the year. However sharp the haemorrhaging of assets was, it stopped very quickly around the turn of the year. Since the beginning of 2009, AUM of the managed account platform have increased by around 20%, to US$6.3 billion at the end of May. Dubois is proud to point out that at no point did they or an underlying manager impose a gate on investors’ capital. “Not one single fund of ours has been gated in the last year,” he says emphatically. This is in sharp contrast to a substantial part of the hedge fund industry, particularly the larger, more established managers who have gates, sometimes nested gates, as well as long notice periods. For example the Cerberus Partners hedge fund has a gate at 16.5% of fund assets.

Deleveraging had an impact on Lyxor last year, as 40% of the capital on the platform backs structured hedge fund products. As Dubois discloses: “Where we know about the specific purpose of the managed accounts, most of the structured products which are backed by Lyxor managed accounts have been put together by the Société Générale structuring team.” He continues: “One well-known disadvantage of having structured products is the presence of gamma. So, by construction, where you have allocations going down, the structure has to sell the underlying fund.” A balancing item, and something which isn’t so well recognised, is that structured products have to be held for some period – they typically have a multi-year lifespan. “The holder of a structured product will in all likelihood recognise it as a strategy,” says Dubois, “with expectations about returns and holding periods attached. The consequence is that the end investor will act logically and is likely to hold the structured product to maturity, and so in practise this is a very stable pool of capital. The holders of individual hedge funds are more likely to panic, and so sell the hedge funds. Overall we like the benefits of having structured products as one of the sources of demand for managed accounts on the platform, but it is only one of the sources.”

Lyxor senior management consider it very important to have a diversity of client groups putting capital into the funds (managed accounts) on the platform. “There is a mix of investors,” says Dubois. “There are long-term investors such as UK pension schemes and Dutch pension schemes. We also have private banks and structurers as client groups.” The experience of Lyxor was similar to that of others in the industry when it came to redemptions last year. “Redemptions were from high net-worth individuals – and those who hold their capital, such as private banks – more than long-term investing institutions. It is telling in this regard that we had no redemptions from pension funds at all recently.”

Index products and UCITS
The UCITS III framework presents both a challenge and a massive opportunity to the hedge fund industry. Lyxor intends to take advantage of the opportunity that UCITS represent by being at the forefront of the trend to turn hedge fund exposures into retail products in Europe. It will do this by building on its existing capabilities. In May last year Lyxor launched the Lyxor Hedge Fund Indices (LYXR), a range of 16 fully investable indices which are calculated and published on a daily basis. Each index is reviewed and rebalanced on a monthly basis. The indices are based on the funds available on Lyxor’s hedge funds platform so the indices are investable. The global index is a combination of strategy indices mirroring global hedge fund industry performance. The 14 strategy indices each correspond to a specific hedge fund strategy, which should help with diversification, but more importantly they are asset-weighted so that they track the performance of the hedge fund industry as experienced by investors.

Lyxor has launched a UCITS III fund based on the broadest index called the Lyxor Hedge Fund Index Fund. This Fund is aimed at giving a large audience access to the performance and diversification benefits of the hedge fund industry. It has also launched the Lyxor Active Edge fund, an actively managed fund allocating dynamically across strategies. “It is expected that funds based on the sub-indices will be used by allocators to hedge funds to fine tune asset allocation,” says Dubois. Say funds of funds or wealth managers take a market view that M&A will pick up: they can allocate on a timely basis to event-related strategies as there is weekly liquidity on these funds, rather than the periodic subscription days available on the underlying single manager hedge funds. This frequency of dealing is a major feature of the Lyxor platform.

Alain Dubois sums up the state of play for Lyxor: “There has always been an acknowledgement amongst investors that there are risks associated with investing in hedge funds. What has happened in the recent past in markets has meant that there has been a better recognition of those risks – so the benefits of our model are better recognised now. So we are now receiving lots of enquiries from all sorts of different institutional investors and funds of funds. Whether they are pension funds or insurance companies, they understand that the managed account structure is the way forward in limiting operational risks of all types, and the advantages of liquidity.”

This better recognition is no longer just a passive nod – it is possible that we are seeing the turn of the tide on flows. It may be an early harbinger, but Lyxor is already in receipt of positive net flows. These have resulted from a lot of direct sales to funds of hedge fund managers, and – to a lesser extent – reviving interest from small institutions.

The nadir?
Lyxor, like most of the hedge fund industry has been through a tough time over the last 12 months. Observers and industry participants tend to focus on the numbers: for the managed account platform specifically assets under management halved, and the number of managers present on the platform has dropped from 150 to 106. However qualitatively it is not all gloom – the drop in hedge fund assets has increased available capacity, and some formerly closed managers have come onto the platform, including several important names in the industry, according to Dubois. The composition of the managers represented on the platform has changed (see Fig. 2), but the quality has, if anything, increased. There has been a net inflow of over US$1 billion on the platform since the beginning of 2009.

Beyond the managed account platform, Lyxor has benefitted from the diversification of running several business units (see Fig.3). It has continued in the tough times to strive hard to be innovative with new product developments. The fund of funds business has done a very good job over the last year, the ETF business has continued with very good liquidity and volumes benefitted from hedge fund trading and the need to hedge. We may only whisper it at the moment, but the nadir may well have been passed for Lyxor and, with a little lag, for the industry.


• Creation of Lyxor FM
• Lyxor AM Platform first funds

• Launch of CAC 40 ETF
• Launch of LDF

• Launch of Turquoise

• 100th Lyxor Platform hedge funds

• Launch of Alternative Risk Transfer (ART) funds

• Launch of bonds/gold/inflation index trackers

• First European buy-and-right ETF and first leveraged ETF
• Launch of Lyxor Quantics and Generis range
• Launch of LGA
• Range of 13 European sector ETFs

• Launch of 13 new ETFs European area

• Launch of four new ETFs on FTSE RAFI strategies