Head of N. American Business Development
Senior investment professional
"We've been offering liquid alternatives to the institutional marketplace for over 15 years,” says Michael Bernstein, Head of N American Business Development at Lyxor Asset Management in New York. "Sometimes these terms get conflated and people start to associate the term liquid alternative exclusively with '40 Act funds and retail investors.
"We want to make the point that lots of different investors have an interest in liquid alternatives and there are many different vehicles that qualify, managed accounts being one of them.”
Kunjal Shah is a senior investment professional at Lyxor, having joined from Arden Asset Management this September.
"Liquid alternatives has been part and parcel of what we do from day one and we've now started to extend our offering to include UCITS-compliant managed accounts. Performance of the three UCITS funds that we've established year-to-date has been good. The plan is to grow the UCITS offering methodically, bringing on board quality managers with good risk-adjusted returns,” confirms Shah.
Last February, just before ESMA published its updated guidelines on ETFs and UCITS, Lyxor launched the Lyxor/Tiedemann Arbitrage Strategy Fund, a merger arbitrage strategy run by TIG Advisors. It was a wise decision. In a little over 12 months the strategy has grown to approximately USD650mn. The version of Winton Capital's Diversified Program has more than USD215mn and the Lyxor/Canyon Credit Strategy Fund, a credit long/short strategy, has assets north of USD190mn.
This shows that demand for liquid alternatives is significant among institutional investors, to whom Lyxor exclusively caters. That three UCITS funds have garnered north of USD1bn alone is revealing.
"UCITS broadens the potential buyers for the products that we have. There are certain investors that are limited to investing only in UCITS vehicles. We have the manager relationships in place, so it's actually rather easy for us to provide this structure for that sector of the market. It's complementary in many ways to offer UCITS funds alongside our existing non-UCITS hedge fund managed accounts,” comments Bernstein.
One might logically conclude that if US hedge fund managers are offering UCITS-compliant versions of their offshore strategies in Europe, then surely it makes sense to launch standalone '40 Act funds to capture US retail investors.
The argument for this, however, is far more nuanced. The US mutual fund market is enormous, highly complex and highly regulated. One cannot draw many comparisons to UCITS, other than the fact that both require managers to provide daily liquidity terms. What many US hedge fund managers appear to be doing in the '40 Act space is take on sub-advisory mandates, in a managed account format, as part of a wider multi-manager product overseen by an investment advisor.
"There's a huge difference between being a sub-advisor to a multi-manager '40 Act product and establishing a standalone product. The benefit of the former to a manager is that they can tap into the growth of this market segment without having to potentially cannibalise their existing business. It's not something an investor can access directly. It's a good introduction to the '40 Act space,” adds Bernstein.
Also, from a compliance perspective, the strategy doesn't need to be fully '40 Act-compliant even though the multi-manager product as a whole has to be. That gives a little more leeway to managers, says Shah, as it is the investment advisor who has to handle all the operational aspects.
"All the sub-advisor has is a managed account with specific guidelines that they must follow. The other important point is that the manager doesn't have to worry about distribution. Like operational oversight, that falls on the shoulders of the investment advisor,” says Shah.
According to a survey released by Deutsche Bank in September 2014, ‘From Alternatives to Mainstream Part Two, total assets managed by '40 Act mutual funds reached a record high of USD257bn by end-2013, representing over 60 per cent growth for the year. Through May 2014, that figure had grown a further 18 per cent to over USD300bn.
These are still small numbers within the overall context of liquid alternatives. For example, Lyxor's managed account business has an AuM of approximately USD12bn.
To further extend the menu of options to its institutional investors, last year Lyxor introduced a new Institutional Share Class on its platform; something that is now available to approximately 40 per cent of the 80 or so managers on the platform.
This new share class was created to cater specifically to investors who didn't want to pay the weekly liquidity premium on offer (alongside transparency and risk oversight). Bernstein notes that the message of transparency and risk oversight really resonated with investors but that the weekly liquidity proposition was something that most institutions felt they didn't need at the time.
"The rationale was, "You're charging a premium for these features of a managed account but we don't want to pay a premium for weekly liquidity that we don't plan on using. Can you offer us the transparency and risk oversight without charging us for the liquidity?”
"That led to us creating the institutional share class, which basically charges nothing over and above what the manager already charges. The only way we make fees is by negotiating a share of the fees with the investment manager. The investor pays the same amount yet as well as getting transparency and risk oversight they still get monthly liquidity; it just requires a larger minimum investment of USD5-10m,” confirms Bernstein.
This is perfect for the mid-tier institution that is not big enough to command its own fee breaks with managers directly and wants the additional benefits of transparency etc, in a managed account but who doesn't want to pay a weekly liquidity premium.
There can be little doubt that one of the primary drivers for investors moving more in to liquid alternatives is the negative experience of 2008 when many were impacted by gatings and suspensions. Nobody wants to go through that again.
Investors want to know that if they need access to cash, they can get that access. "It could also be a cash management reason. Plenty of investors are sitting on cash and liquid alternatives could be a good option to get enhanced returns vis-à-vis money market funds,” opines Shah.
That there are so many products available to investors today is a positive for the industry. What's interesting with '40 Act funds in particular is that many of these products can collect assets without long track records. That separates them from long-only '40 Act funds that absolutely rely on track records and a certain degree of stability.
"There's enough demand out there for something new and different, such that people are willing to take a punt on something that's not necessarily proven. However, what I foresee is a situation where eventually there will be more products than the market demands and many of the products currently being launched won't be successful,” suggests Bernstein.
What seems to be emerging in the hedge fund firmament is a richer, more diverse fund ecosystem where investors can avail of different liquidity terms. This is the effect that liquid alternatives is having. Where once the decision was binary – one either chose an illiquid offshore structure or a liquid managed account structure – there are now myriad options.
As Shah warns, however, investors have to analyse fund structures on their own merits. Are they being compensated for reduced volatility or for greater illiquidity?
"There are funds out there that deliver good risk-adjusted returns for low volatility and those have a place in portfolio construction. Then at the other end of the spectrum you have private equity funds that offer more of an illiquidity premium that investors can exploit.
"I think that's where institutional investors come into play; where do they need liquidity? What level of returns do they need to achieve based on the liquidity profile of different investments? Then they can construct their portfolio accordingly.
"There is a trade-off between liquidity and returns. You could put your cash into money markets yet get close to zero returns. A '40 Act fund or UCITS could be a way for investors to put excess cash to work for a higher return. It depends on the investor's investment philosophy. What role do daily, weekly or monthly liquidity structures play?” says Shah.
Berstein says that institutions are taking a barbell approach to building alternative exposure.
To the right of the barbell, investors want access to long-term investment strategies that are more at the illiquid private equity-like end of the spectrum i.e. distressed credit, special situations strategies etc. Indeed, hybrid fund structures, incorporating dual layers of liquidity, have become increasingly popular for investors happy to lock up part of their capital over a longer time horizon to harvest the illiquidity premium potentially on offer.
To the left of the barbell, they want exposure to more liquid strategies that have historically only been available in relatively illiquid wrappers.
"That's what's under pressure here. These liquid alternative strategies give investors exposure to those hedge fund strategies but with more liquidity. It's becoming harder for managers to defend their turf if they only offer quarterly or semi-annually liquidity.
"What we are seeing is a push towards this liquid end of the spectrum. However, as you move towards there you are sometimes giving up investment opportunities. You can't necessarily run a strategy in a daily liquidity format that has historically been running offshore in a semi-annual liquidity format.
Indeed, some strategies are just not suitable to invest in for enhanced liquidity, such as activist strategies.
"Expanding on Kunjal's earlier comment, at what point on the liquidity spectrum is the right cost benefit for the investor? Institutions are either going all the way to a daily liquidity '40 Act vehicle or, in some cases, stopping short of that and opting for a weekly or monthly managed account, which should in theory provide them with attractive richer opportunity set.
"It's now about deciding what degree of liquidity the investor wants, and at what cost. That's the new analysis that investors are now making. Daily, regulated fund structures are attractive in theory but investors need to realise that they may come at a cost of performance,” concludes Bernstein.
