| Lionel Erdely: Managed accounts cannot completely mitigate all of the risk of investing in hedge funds (Photographs by Chris Clinton) |
While the fund-of-funds industry has been shrinking, Lyxor Asset Management is having a growth spurt. The $128.5 billion subsidiary of Société Générale hauled in $1.4 billion in new assets last year and recently began finalizing negotiations with the $132.5 billion California State Teachers’ Retirement System to manage an unspecified amount of the pension’s hedge fund allocation. Lyxor’s alternative investment division now manages $27 billion, of which $10 billion is invested through managed accounts.
Lionel Erdely, Lyxor Asset Management’s chief executive for the U.S., says part of the reason for that growth is the firm’s advisory business in the U.S. Erdely, who joined Lyxor in 2002, moved to New York in April 2009 to lead the business, which formally started in September 2009.
If the firm succeeds in cracking the U.S. market, it will represent a significant advantage for Lyxor, which is vying to expand its business in the toughest environment funds of funds have ever faced. With the industry’s total assets down 46% since 2008, and many institutional clients ditching funds of funds altogether to go directly into hedge funds, fund-of-funds managers must now offer their clients more than just due diligence and manager selection skills.
They must also make sure investors’ expectations are realistic. Erdely says part of the problem was that hedge funds were sometimes marketed to investors as funds that would never lose money in up or down markets. But he thinks investors now know better and that funds-of-funds managers are getting more responsible in their marketing methods.
“A fund of funds cannot tell a client, “I have access to a magician,” says Erdely. “That time is over. This is a good thing.”
He says Lyxor avoided falling into that kind of thinking because its long-running managed accounts platform, which allows institutional investors to access the managers in Lyxor’s portfolio with more control over their own funds and which gives Lyxor full transparency on the managers in its portfolio, which includes such industry stalwarts as Bridgewater Associates, Paulson & Co. and Tudor Investment Corp.
Still, Erdely says funds of funds still have a valuable role to play for institutional investors, and those that do survive will offer better services to their investors than they did before the financial crisis. “The identification of new talent takes time and talent,” he says. “This is something funds of funds can bring. The changes in the asset management industry will be better for investors and asset managers. There will be more visibility. Everyone understands that hedge funds are not magicians.”
Of course, they will also need to put up stronger numbers than they have in the last few years. Funds of funds returned just 4.86% in 2010, according to the Invest-Hedge composite index, compared with 9.15% for the AR Composite Index.
“What matters is performance,” Erdely says. “If funds of funds show they can really create this diversification and solid performance, of course they will survive. The good funds of funds will be successful.”
Lionel Erdely: Everyone understands that hedge funds are not magicians |
Erdely thinks the strongest funds of funds will be those that can offer transparency and also ensure that they are structuring their investments in a way that avoids the asset/liability mismatches between funds and their investors—an imbalance that he believes caused the crisis. “What is key to me is not to offer liquid investments, but to ensure there is no liquidity mismatch,” says Erdely.
One way Lyxor offers this is through its managed accounts platform. So far, Lyxor’s plan seems to be working: After contemplating a move to hire a consultant and go direct, CalSTRS ultimately scrapped the plan in favor of hiring Lyxor. (Erdely declined to comment on the deal.)
AR staff writer Suzy Kenly Waite caught up with Erdely to discuss Lyxor’s plans for the future and how the fund has managed to flourish in a rapidly shrinking industry.
AR: Funds of funds are in survival mode, and the thinking in the industry is that they must adapt or die. How are you ensuring that Lyxor remains relevant in what some argue is a dying industry?
Lionel Erdely: I strongly believe that funds of funds have a future, but with a different prerequisite. After the Bernie Madoff fraud, the negative performance of 2008 and so on, the traditional fund-of-funds business model is clearly at risk. It’s evident that institutional investors are not interested in this model.
There is no secret: Hedge funds are not magicians. They are not making money no matter what the environment. This idea was oversold.
We never believed this because we had the full transparency, and we could analyze the performance drivers. We have an investment process which is clearly adapted to the reality of what hedge funds are, which are animals with beta and alpha. They perform in different environments. You can have an excellent fund, but when the environment is detrimental, they have bad performance. Does this mean they are bad? No. It means the environment is good for given hedge funds and not for others.
We use hedge funds as a way to diversify equity exposure for institutions. History shows that hedge funds are capable of doing this. We have full transparency on managed accounts, very good transparency for hedge funds, and good liquidity generally. This way we do not have to navigate in the dark. Institutional investors expect their fund of funds to provide due diligence and assemble hedge funds. For us, it’s not enough. We expect so much more.
AR: You don’t think the industry is going to disappear completely?
Lionel Erdely: Hedge funds have recovered three-quarters of the assets since the peak of 2007. We are almost at the level reached before the crisis. Ninety percent of the assets raised since the crisis were done so by firms with more than $5 billion. I don’t know any other industry where there is such a concentration of inflows. Clearly, institutional investors need diversification, and hedge funds provide this.
It’s true that hedge fund investments via funds of funds have decreased. That’s obvious. This is partially because institutions who have the resources to perform due diligence research and who want long-term investments and no real dynamic allocation can invest directly in very big firms with an institutional pedigree. After Madoff, many people followed the mistakes of a few players in the industry. And it’s true that assets have decreased. But I think redemptions are over. Most funds of funds will stabilize and increase their investments into hedge funds, especially when the good funds of funds show that their performance is still there.
AR: Will investors continue to pay the extra layer of fees that funds of funds charge if the performance continues to be mediocre?
Lionel Erdely: I think the returns were boring last year, but you have a lot of firms who demonstrated their capability to diversify and have a consistent track record. This is why institutional investors invest in funds of funds.
We raised $1.2 billion last year. I’m not saying that everyone is going to raise assets. I’m saying that institutions who have strong risk management, strong values and can deliver consistent returns will continue to have inflows from institutions. There are a lot of strong names who really showed their capability to navigate the crisis pretty well and offer diversification to their clients. It’s a lot of work to invest in hedge funds. Charging fees for in-depth due diligence, ongoing monitoring, top-down analysis, optimization of a portfolio, constant rebalancing, risk management and analyzing transparency is all extremely important. The fees are worth this.
What matters is the management of the performance objective. If you had the choice between two funds, one charging 1.5% and 10% and one charging 2% and 20%, but the 2% and 20% constantly outperforms the first one by 3% with lower volatility and better diversification, you will pay the higher fees. Institutional investors have the same approach. The fees are justified by the quality of service and by the value added in terms of performance.
However, the funds of funds who cannot demonstrate the value added in terms of performance, risk management, diversification and services will have their businesses challenged.
AR: Some funds of funds are even advising clients on how to go direct, in order to diversify the services they offer. Is Lyxor doing this?
Lionel Erdely: Yes, of course. That’s why we think Lyxor is in a great position. If a client wants to go direct, we have no problem with that. We can advise them.
One option is to go via our managed account platform. If a large institutional investor wants to go direct but wishes to avoid operational risk and reputational issues, managed accounts are a very solid solution for them.
Put yourself in the shoes of a chief investment officer of a pension plan. Investing in hedge funds makes sense, as it diversifies your portfolio. But if that hedge fund ends up in a headline in the Wall Street Journal, this is a big problem for the pension plan and the CIO. Solid performance does not make up for these reputational risks and operational risks—it creates asymmetry. You want to protect yourself from this type of situation, and managed accounts are a powerful solution. I’m not saying that they are the only solution, but they are a powerful solution.
AR: How else is the fund-of-funds industry changing?
Lionel Erdely: Changes are clearly going in the right direction for investors. That’s the reason I’m optimistic of the future of this industry. Institutional investors want increased transparency, better risk control and so on from funds of funds and hedge funds. Funds of funds have a lot of services to offer institutional investors. But they have to offer high-quality service, deliver performance and create value through their asset allocation and due diligence process. Funds of funds with an institutionalized platform have a strong role to play.
AR: Managed accounts have faced some criticism, with some investors arguing that managed accounts give preferential treatment to larger investors since they can get their money out faster. How would you respond to this argument? What are Lyxor’s terms?
Lionel Erdely: In answering, it is important to emphasize that Lyxor maintains a co-mingled fund of hedge fund platform, where we partner with numerous hedge fund managers who are retained as trading advisors on the Lyxor fund but are not otherwise owners or controllers of the managed accounts or their assets or operations. This is a marked difference between our platform and a managed account that would be run by the fund manager themselves alongside their own fund.
Investors can gain access to Lyxor managed accounts through an initial investment of $100,000 and subsequent investments of $10,000. This certainly creates broad opportunity for investors of all sizes to access the benefits of our platform. This also encourages a diversification of investors in each managed account. This is in contrast to a managed account managed by a hedge fund manager directly for one client, for example, where that client’s single decision to liquidate could adversely impact other investors in the fund.
AR: Another criticism is that despite offering good transparency and liquidity, they still can’t protect their investors from losses. What is your response to these criticisms?
Lionel Erdely: Managed accounts cannot completely mitigate all of the risk of investing in hedge funds. Even where managed account platforms have an advanced setup that comprehensively controls for risk, as Lyxor does, there is always that element of market risk that will hopefully drive returns, but can of course also drive losses. Managed accounts do give investors an important advantage, however—the liquidity and transparency necessary to spot and rapidly react to trends and act to minimize losses. Likewise, liquidity can be a double-edged sword, but this is, and has always been, a fundamental commitment of Lyxor’s, and we have demonstrated that we can accommodate sizable asset flows while protecting both our clients and the platform.
AR: Are most hedge fund managers willing to take on managed accounts given the additional costs they can incur?
Lionel Erdely: There are added costs, financial and otherwise, to managed account investing, and each investor and hedge fund manager has to perform their own cost-benefit analysis in this regard. Our experience has been that institutional investors place a premium on the benefits of proven managed account platforms like Lyxor’s in terms of their ability to reduce risk and provide an enhanced framework for hedge fund investing. Likewise, managers value the asset diversification potential of partnering with an established managed account platform.
AR: What do you offer your clients through your advisory business?
Lionel Erdely: We want to understand why they want to invest in hedge funds. We don’t arrive with a product. We listen to our clients and design something which suits their needs. Typically, pension funds and insurance companies go into alternatives precisely because they need diversification. So first, we try to understand why the client has concluded they want to invest in hedge funds. Then comes the solution. Our flexibility is to offer liquid and nonliquid solutions.
We are known for our managed account platform. Investors can invest directly in managed accounts, directly into hedge funds or we can combine both. There is no compromise on transparency or liquidity. That’s very important. What matters is to have no liquidity mismatch between the assets in the portfolio you’re constructing and the liquidity that your client expects. Illiquid investments did not cause the crisis. The liquidity mismatch did.
We always ask our clients, what are your liquidity needs? Sometimes they have a two-year or three-year investment horizon. Sometimes they want to have 100% of their cash very quickly. It really depends. There’s no best solution. It’s the balance of everything.
AR: What do you look for when deciding whether to invest in a hedge fund manager?
Lionel Erdely: What matters to us is the transparency. If we don’t have access to information, we don’t do work with them. It does not mean they are not good. It’s just not our business model. It’s not what we sell to our clients. Our clients do not need us if we do not do our work properly. Second is the identification of the reputability of the talent and consistency of the track record. If a manager was right one time, that’s great. Can he repeat this? Third is the consistency between what the portfolio managers say and what is in their book. Some managers are very articulate but bad at managing money. Some are not very articulate but are very talented portfolio managers. The consistency of all of the professionals within the firm is also important. If the CFO says something that’s different from the COO, the risk manager, the portfolio managers and the traders, that’s a big concern.
