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ALTERNATIVES - Structured for Success

Lyxor Asset Management and Morgan Stanley have just the alternative for wary investors.

IT’S BEEN A ROUGH YEAR FOR Société Générale Group. Following a €4.9 billion ($7.2 billion) loss by stock-futures trader Jérôme Kerviel, France’s second-biggest bank may be forced into the arms of a suitor. But ironically, the exploits of Société Générale’s rogue trader could benefit the bank’s Paris-based Lyxor Asset Management subsidiary, which was set up in 1998 because European risk departments had become afraid of hedge funds. “Many Swiss banks lost fortunes on options via structured products based on Long-Term Capital Management,” says Lyxor chairman Alain Dubois, who joined the group in 2000 after specializing in structured products at Commerzbank of Frankfurt and Paris-based Lazard Frères et Cie. “The challenge was to create a new form that could guarantee a very high level of transparency and restore confidence, yet still deliver the high returns.”

The Lyxor Managed Account Platform has re-created 170 accounts, which are managed almost entirely from inside the organization, the exception being the “trading advisers,” who approximate the investment strategies of their original, external benchmark hedge funds. The platform manages $36 billion in alternative investments across a wide range of strategies, with its benchmark funds drawn from many of the world’s best-known hedge fund companies.

All of the managed accounts are limited liability companies, registered and regulated by the Jersey Financial Services Commission and deposited with an independent prime broker. Lyxor sets strict investment guidelines and risk limits for its trading advisers. The platform also releases weekly liquidity and net asset value calculations, an improvement over the monthly and quarterly updates for regular investors in its benchmark funds.

Lyxor standardizes subscription and redemption procedures, with a single settlement schedule across the managed accounts to encourage their use as underlying investments for structured products. And because Lyxor sets its own entry rules, the platform can offer a lower entry hurdle than most of its benchmark funds: $100,000 for eligible collective investment schemes offered to the public and $250,000 for other qualified investors.

For its 85-basis-point fee, the platform guarantees adherence to Société Générale’s standards. It also ensures that the structured products it creates — based on the underlying managers’ benchmark funds — are solvent. The group famously denied Greenwich, Connecticut–based Amaranth Advisors’ application because the fund wouldn’t meet Lyxor’s transparency requirements.

From that perspective, the managed account platform achieves its goal: to assuage institutional fears about hedge funds and stop the next LTCM or Amaranth from being the underlying security that loses money for Société Générale’s

biggest banking clients. “What we have done is make investing in hedge funds safer than it once was,” Dubois says.

Lyxor has competition. Morgan Stanley unveiled its London-based LiquidFunds Program last summer with similar ambitions, while charging less than half the fees that Lyxor does. Like Lyxor, LiquidFunds aims to standardize the returns of a select group of hedge funds, impose tough corporate governance conditions and a disciplined vetting process, and lay the foundation for structured products that appeal to a broader clientele than direct hedge fund investments do. The difference is that LiquidFunds employs less infrastructure.

Instead of internalizing its managed accounts, LiquidFunds makes platform participants responsible for running their own funds. The program provides a template for creating a managed account that complies with Morgan Stanley’s governance rules and meets its hurdles for prime broker, auditor, administrator, due diligence, transparency and investment infrastructure standards. All of the managed accounts are Cayman Islands–listed and open to a minimum $500,000 investment in equal share classes without capacity restrictions. LiquidFunds, which outsources due diligence to Greenwich Alternative Investments of Greenwich, Connecticut, and the risk analytics and daily reporting function to New York– and London-based GlobeOp Risk Services, charges only 35 basis points.

Morgan Stanley has pledged $200 million to equally seed the first 15 managed funds on the LiquidFunds platform, which it plans to grow to about 60 funds. All of the funds are at least three years old, with assets under management ranging from $100 million to $2 billion.

For Morgan Stanley and Société Générale, the potential profit from selling structured products was a key motive for investing in their respective platforms. Says Marc Thévenin-Biguet, a Morgan Stanley Investment Management vice president responsible for LiquidFunds, “Our greatest contribution is that we help regular funds to distribute to a wider audience and become the basis for structured products that can inevitably reach even more investors.”