On page 56 of Société Générale's 2003 annual report, in a 52-word sidebar without a picture that appears halfway down the left-hand side of the page, is a cryptic reference to one of the big French bank's lesser-known but more intriguing enterprises. Noting that the bank has developed a "unique range of guaranteed alternative investment products," the text states simply: "Lyxor Asset Management, a subsidiary of Société Générale Group, is backed by a risk-management platform
"For most clients Lyxor is invisible," concedes its chairman, Alain Dubois, who once structured OTC derivatives for Lazard Frères et Cie. and Commerzbank. "The only name they see is Société Générale."
The 48-year-old Dubois, who likes it that way, had better enjoy Lyxor's low profile while it lasts.
This curious company-within-a-bank represents a distinct new species within the realm of asset management, one born on the littoral plain where capital markets and fund management converge. Lyxor's product mix consists of alternative investments -- chiefly hedge funds tucked within managed accounts -- exchange-traded funds and exotic structured products. Dubois reports not to SocGen's money management chief, Philippe Collas, but to the bank's global head of equity derivatives, Christoph Mianné.
Like many a natural hybrid, this strange animal is thriving. Lyxor's assets under management have shot up more than sevenfold, to some E30 billion ($38.4 billion), since the start of 2001. The SocGen unit counts thousands of clients among the bank's more than 15 million customers, institutional as well as retail, spread all over the world. (Two thirds of Lyxor's customers are in Europe, with the remainder split between North America and Asia.) And although SocGen does not break out Lyxor's profits from those of the derivatives group, analysts reckon that it earned roughly E200 million in 2003, the bulk of it from hedge-fund-linked structured products. If so, that would be equivalent to three quarters of the net income of SG Asset Management, SocGen's traditional asset management business -- which happens to have eight times Lyxor's assets. And it would represent 9 percent of the profits of SocGen itself.
To Dubois and his colleagues, Lyxor is nothing less than the prototype of the 21st century money management firm. "If I were an [investment] institution, I would use structured products to solve my asset and liability problem, hedge funds for alpha and ETFs for market exposure," he declares. "Hedge funds and structured products are stealing market share from traditional managers, and indexed management is also progressing. I like that combination of business lines."
Is Lyxor, then, the greatest thing since the fresh baguette? Critics are quick to contend that no hedge fund platform can possibly attract the best funds, which tend to be closed to new investors. Others snipe that Lyxor has flourished only because its structured products, with their capital guarantees, were able to feed off rampant investor pessimism during the bear market; now that markets are reviving, they say, investors won't be so inclined to pay extra to protect their capital. Moreover, skeptics warn that structured products in general are opaque by their very nature and have a history of disasters, from portfolio insurance to "precipice" bonds. (The latter offered a high yield, but their return of capital at maturity was linked, typically, to a stock market index, and that proved to be a very bad idea for investors during a bear market.)
For his part, Dubois is dismissive of such criticism. "We are offering an alternative to traditional management, so of course we are seen as a threat," he says with a Gallic shrug.
Gilles du Fretay, founder of one of France's oldest fund-of-hedge-funds businesses, HDF Finance, professes a grudging respect for his Parisian neighbors at Lyxor. "They are serious people and have developed a good business in a short time," he says. Although, he adds, "in France, it certainly helps to have the backing of a large parent." The case for Lyxor's approach got a boost in 2002 when Deutsche Bank set up Xavex Alternative Investments in London as a virtual replica of Lyxor, complete with a former Lyxor executive, Jean-Marie Barreau, as its head.
Lyxor is like no money manager extant today (barring the smaller Xavex). It has no chief investment officer, no head of equities or bonds and certainly no portfolio all-stars. None of Lyxor's 114 staff members pore over profit and loss statements or fret about exposure to Parmalat.
Lyxor has been unabashedly different ever since it was conceived almost by accident within SocGen's derivatives group in the late 1990s. Hedge funds were hot, and Jean-Pierre Mustier, who then headed derivatives and today runs SG Corporate & Investment Banking, wanted to write structured products, such as options and warrants, against hedge funds and funds of hedge funds, to sell to institutional clients. Mustier and his confrères were financial engineers who needed sound construction materials -- in their case, hedge funds. SocGen's risk managers, however, balked. Their qualms: Notoriously secretive hedge funds lacked transparency, and they offered too little liquidity. Then as now, hedge funds often allow investors to buy or sell only once a quarter, although some do offer monthly liquidity. Others impose a one-year lockup.
Lyxor represented a solution to this quandary that was structured as ingeniously as one of SocGen's derivatives products. Although wholly owned by the bank, it was set up as a legally separate entity under the authority of the Commission des Operations de Bourse, France's stock market regulator. This enabled SocGen to erect a credible Chinese wall between Lyxor and the bank's equity traders.
Lyxor was then able to persuade hedge fund managers to establish managed accounts that mimicked their funds. The accounts were set up as offshore limited liability companies whose shares trade on the Irish Stock Exchange, thus complying with European Union hedge fund regulations. Lyxor funnels assets to the participating hedge funds from either funds of hedge funds that it runs for SocGen or from third-party investors.
The sums at stake are eye-opening: As of January, Lyxor had channeled E5.1 billion to managed hedge fund accounts on behalf of its third-party clients and controlled a further E6 billion in more than 300 funds of hedge funds.
In return for the bounty of assets, the 114 hedge funds that now make up Lyxor's managed accounts disclose their underlying positions to the firm and permit weekly, rather than quarterly, in-and-out trading. Here the Chinese wall is critical. The hedge fund managers need to be assured that SocGen's equity traders don't know their positions, so they can't exploit them and harm their funds.
The Lyxor hedge fund club has a strict code of conduct, however. Before a managed account is established, Matthias Ranke, Lyxor's head of risk, lays down rules for that hedge fund. "The idea isn't to be prescriptive," he explains. "We monitor what they do and produce guidelines that are in line with their investment strategy. What we don't want them to do is stray from their strategy because that changes the risk profile of our products if we structure funds around them." If a hedge fund manager breaches the guidelines, Lyxor can terminate the account.
"It is demanding in terms of transparency and due diligence," says Alan MacLeod, head of hedge funds at Edinburgh, U.K.based Martin Currie, whose Japanese fund is available on Lyxor's platform. "But the quid pro quo is very acceptable: Lyxor is a good source of funds."
Lyxor's managed-account platform has attracted some big names among U.S. hedge funds, from distressed-debt specialist Appaloosa Management in Chatham, New Jersey, to CTA and macromanager Graham Capital Management in Stamford, Connecticut, to long-short player Boston Partners.
Moreover, Lyxor has emerged as a vital supplier of assets to fledgling European hedge funds. For instance, it was an early investor in five-year-old AlphaGen Capella, the highly successful E2 billion long-short European equity fund established and still managed by Roger Guy of Gartmore, the once-traditional U.K. money manager that has become an incubator of hedge funds. Lyxor invested in Gartmore's Avior, a U.K. long-short fund; Cepheus, its small-cap European long-short; and Altae, a European sector neutral product. All were launched after 1999.
"It has been a good working relationship," says Gartmore's hedge fund account director, Graham Martin. "We get seed capital from an investor we know, and Lyxor can get capacity in funds to tailor their derivative products."
In 2001, Lyxor opened its managed-account platform to investors other than SocGen clients. Each of its funds now issues B shares that can be bought by such third parties as funds of hedge funds, private banks and family offices. The minimum investment for collective schemes is $100,000; for all others, including wealthy individuals, it's $250,000. Lyxor charges 95 basis points on top of the trading adviser's fee.
The platform format has its detractors. Mehraj Mattoo, global head of the alternative investments group at Dresdner Kleinwort Wasserstein, describes it as a "self-selected universe." The best hedge fund managers, he says, "don't need money, so almost by definition Lyxor operates a platform for second-tier players." Dubois counters that "if you define the best hedge funds as those hedge funds that are currently the biggest, you take a very odd view of likely future winners and losers."
Skeptics also point out that the in-house risk management and the transparency afforded by the managed accounts don't necessarily allow the firm and its clients to escape unscathed from hedge fund blowups. One fund on its platform, Boston-based Beacon Hill's Bristol Fund, a mortgage-backed-securities specialist, was hit by an estimated $400 million loss in the summer of 2002 because of allegations involving misstated returns. In November 2002 the Securities and Exchange Commission charged Bristol with a violation of the antifraud provisions of the Investment Advisers Act, and the fund stopped trading the same month.
"If the question is, Can we spot every potential problem at every hedge fund? then the answer is obviously no," says Dubois. "We cannot see the future, but we can deal with the risks we do spot, and with transparency we have a better chance than most."
He contends that because of their weekly trading privilege, Lyxor's investors in the Bristol fund had the chance to bail out at the end of July 2002, when its problems first surfaced. By contrast, Dubois says, direct investors in the fund had to wait until September. "In the meantime," he notes, "the fund had lost an additional 40 percent of its value."
Unigestion, the Geneva-based fund-of-hedge-funds manager with E3.5 billion in assets, appreciates the Lyxor methodology. "Our institutional clients like the transparency and liquidity of managed accounts," says Antoine Prudent, Unigestion's head of hedge fund product development. "We like it, too, and thought that now that Lyxor's platform has a critical mass of funds, it is the right time to launch products based on it."
Accordingly, Unigestion, in conjunction with Lyxor, is coming out with a series of funds of funds under the rubric Galaxy Fund that are based entirely on funds from the Lyxor platform. But Unigestion's long-term intention is to create with Lyxor single-strategy funds aimed at institutions. "Our belief is that as institutions grow increasingly familiar with this asset class, they will look to choose their own strategic allocation to hedge funds consistent with their overall asset allocation profile," says Prudent. "There will be a change in the relationship between institutions and fund-of-funds managers, and we want to be ahead of the curve."
After hedge funds and funds of hedge funds, the logical next step was hedge fund index products. Lyxor has hooked up with Morgan Stanley Capital International to offer the MSCI Hedge Invest Lyxor Tracker Fund. Launched last July, it consists of 82 hedge funds employing 13 investment strategies. All of the funds are found on Lyxor's platform. Lyxor sees the index primarily as the basis for its tracking funds and structured products.
Baer Petit, head of MSCI in Europe, says that when his product developers were looking to create an investable hedge fund index, their most important concern was liquidity. "That is why we came to Lyxor," he says. "Our expertise is as a creator of index methodologies. Lyxor has established a platform of hedge funds that also offers the liquidity an investable index needs."
Soon after the MSCI index was inaugurated, Lyxor introduced the tracker fund based on it and listed the fund on the Irish Stock Exchange. It charges 55 basis points (plus the management fees paid to the underlying funds), making it a far less expensive way to invest in a basket of hedge funds than through funds of hedge funds, which typically charge management fees of 1 to 2 percent plus performance fees of 0 to 20 percent of any gains above the relevant benchmark (along with fund fees). Last July, Lyxor introduced two French versions of the tracker fund, one for retail investors, the other for institutions.
"When I talk to institutions about hedge funds, they don't talk about brilliant funds or managers, they talk about the diversification effects of owning an asset class," notes Lyxor's Dubois. "This index is a tool for exposure to the asset class. If that is what investors want to buy, they should buy it as cheaply as possible."
The tracker funds have already spawned several SocGen structured products, including capital-guaranteed and leveraged funds. And Dubois is confident that other banks will also use Lyxor's tracker funds as the underlying asset for their own alternative structured products.
DKW's Mattoo is not convinced of that. "There are better hedge fund indexes, including the Hedge Fund Research product, which we have used for structured products," he says. John Godden, HFR's managing director in Europe, says that "we build our index from the bottom up, choosing the funds we believe fit best -- we are not constrained by what happens to be on a platform." That said, MSCI has a liquidity edge and a reputation for producing indexes with high standards for transparency in construction methodology.
Managers of funds of hedge funds, who control more than $200 billion worldwide, say that they're curious about investable hedge fund indexes but that they are neither particularly impressed nor threatened by them. "There is a difference between an index of stocks in a market and an index of managers who might choose to be on a platform," says Paul Dunning, CEO of London-based HSBC Republic Global Investments, which has more than $3 billion invested in hedge funds. "A stock index meaningfully captures the investment opportunity. These indexes do not. Investors should be very wary."
The engine that ultimately powers Lyxor is not the hedge fund operation but the structured-products business built around it. Of Lyxor's E30 billion in assets, E13.8 billion resides in structured funds -- some 250 of which Lyxor has sold since it was founded.
Lyxor's director of structured products, Xavier Saudreau, compares the firm to a restaurant that adapts its dishes to prevailing tastes. "Distributors can treat us like an à la carte menu," he says. "They pick any underlying index, basket of stocks or payoff profile they want, put it inside any fund wrapper and we structure it. Costs are low because there are huge number of funds spread across a fixed-cost base."
Of course, the current boom in structured products grew out of retail investors' postcrash search for some sort of guarantee for their capital but with maybe an equity kicker to boot. Now retail demand for such guaranteed products seems all but insatiable. Virtually nil before 2001, sales of guaranteed funds surged to more than $10 billion in France and $7.5 billion in Spain last year, according to FERI Fund Market Information.
Yet, as Saudreau notes, structured products also slot neatly into institutions' asset-liability-matching mind-set. "Traditional asset management solves only the asset side of the equation," he points out. "What we do with structured products is start with the goal of a retail investor. That is basically the same as the liability of a pension fund. We then structure a product to hit that goal within a set degree of risk tolerance."
Lyxor has been enormously successful selling structured products to retail investors in Europe under the SocGen name and through the big bank's vast client network -- which peddles about 20 percent of Lyxor's structured products -- as well as through other major distributors, such as France's post office, La Poste, and Italy's largest insurer, Generali. One of its most popular products -- with more than E1 billion in sales throughout Europe -- is a fund called Emerald, which locks in the highest value of a basket of 12 international blue-chip stocks for up to eight years.
Lyxor has one business line that mainstream money managers can identity with: exchange-traded funds. After a 45 percent spurt in ETF assets last year, the company runs E5 billion in nine funds tracking everything from France's CAC 40 (since December) to Italy's MibS&P index. Lyxor has a 21 percent share of the burgeoning European ETF market, according to Morgan Stanley & Co.
Unlike other Lyxor products, which are sold through distributors, the ETFs are sold directly. "The management fees are so low (0.165 to 0.5 percent) that there is no money to spare for distribution," explains Isabelle Bourcier, global coordinator of ETFs for Lyxor. The upshot is that the firm's market for ETFs in Europe has thus far been limited to institutions and hedge funds.
"The ETFs are a valuable tool for investors that want to be long or short the cash market," says Bourcier. "In the past, institutions that may not have been allowed by their clients to trade futures may have used a single stock, like Alcatel or Vivendi in France, as a market proxy. We have seen just how volatile individual stocks can be."
Lyxor uses its capital markets savvy and its SocGen connection in marketing ETFs. In January it launched the EuroMTS Global Master Unit, the first-ever ETF to track Europe's government bond market. SocGen's fixed-income division as well as Paris-based investment bank CDC Ixis is a market maker for the Euronext-listed fund. "It is obviously a help being a part of Société Générale because liquidity is absolutely central to the success of these products," points out Lyxor's Bourcier.
"We have solutions for anyone who is unhappy with traditional asset management," Alain Dubois says. "Fortunately for us, that seems to be a lot of people."