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Stefan Keller, Head of MAP Research, Lyxor Asset Management

Hope for the best, prepare for the worst

The once-in-a-generation uncertainty about sovereign debt has risen further as cyclical worries have resurfaced, says Stefan Keller, head of MAP research at Lyxor Asset Management….

During the summer months sovereign stress has spilled over to the banking system, pushing up credit and market risks. Both the dramatic debate about the US debt ceiling and the deterioration of public finances in European peripheral markets have shaken investor confidence. Clearly, higher sovereign risk premiums have disrupted bank funding markets.

For the first time since October 2008, risks to financial stability have increased, signalling a potential reversal in progress made over the past three years. As concerns have eroded confidence in broader markets, alternative investments offer a credible solution; hedge funds give access to implied assets, arbitrage strategies and optionality in pay-outs.

So, what has been hedge fund managers’ responses to the market turmoil during the summer months? The L/S Equity managers on the Lyxor Managed Account Platform (“MAP”) have an asset-weighted net exposure of 20% as of mid-September. This number compares to a net exposure of 35% early July. Similarly, Special situation managers on the Lyxor MAP have cut their net exposures from 47% to 21% during Q3. This helps to explain why “high beta” strategies declined along with the S&P500 index.

Digging into greater details, we can make three observations. First, country exposures to the European periphery remain negligible. Mid-September, all 100+ funds on the Lyxor MAP show a net exposure of just 9bp to Greek equities, sovereign and corporate bonds. Second, sector exposures reveal a defensive positioning: L/S Equity managers have cut net exposure to Industrials from 8% in June to 3% in September, to Consumer Cyclicals from 6% to 3% and to Financials from 9% to 2%. Third, CTAs have done their job (as expected) and showed decorrelation during the drop in risky assets. The bottom line here is that performance dispersion has been high both at the strategy and the fund level.

How did hedge fund investors pass the summer? Are they heartened by the industry’s overall resilience? Flows on the Lyxor MAP reveal that investors have continued during September their rotation towards hedge funds with less equity directionality. The beta of the inflows has been below the beta of the outflows over the last six months, with the exception of the month of July. It therefore comes as no surprise that Merger Arbitrage – giving access to deep value – currency trading and CTAs enjoyed the strongest investor appetite in this context. By cutting exposures significantly over recent months and reducing equity directionality, hedge fund managers and investors have prepared for the worst.

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