EXPERT OPINION
MARCH  2014
IN V EST M EN T INSIG H TS FRO M LY XO R AS SE T M AN AG EM EN T
LYXOR ETFs QUALITY PROMISE
Lyxor’s ETFs undergo a series of quality
control checks which ensure that
the funds exceed current regulatory
standards. In this expert opinion Lyxor
Asset Management’s head of risk control,
compliance and internal audit outlines the
key elements of Lyxor ETFs quality promise.
Eric Talleux
Chief Risk Officer,
Lyxor Asset Management
Following a series of financial crises in recent years,
the European Securities and Markets Authority (ESMA)
recently reinforced its rules. In 2013 ESMA introduced
new guidelines for UCITS funds, including ETFs, affecting
in particular the way such funds invest collateral, manage
counterparty risk and lend securities.
The publication of these guidelines, to which Lyxor Asset
Management contributed its expertise during a series of
consultations, has also had the consequence of reinforcing
the role of asset management firms’ risk functions.
The principal mission of this risk function is to create an
investment team tasked with protecting investors’ interests.
Eric Talleux, Head of risk control, compliance and internal
audit at Lyxor Asset Management, sets out the model
used by Lyxor to ensure that the interests of investors in
the firm’s ETFs are safeguarded. This model goes well
beyond a simple application of ESMA’s guidelines.
LYXOR ASSET MANAGEMENT PIONEERED THE
ETF SYNTHETIC REPLICATION TECHNIQUE. IT
REQUIRES THE FUND TO ENTER INTO A SWAP
CONTRACT. WHAT DOES THE SWAP CONSIST OF?
The swap is a bilateral contract between the ETF issuer, in this
case Lyxor Asset Management, and an investment bank, called
the swap counterparty. The swap counterparty commits to pay
the return on the index tracked by the ETF (plus the revenues
on the index constituents, minus taxes and replication costs, if
applicable), receiving in exchange the return on the assets held
by the fund. From an investor’s perspective, the value of the
swap is guaranteed by the physical assets held by the fund,
which perform the function of collateral.
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EXPERT OPINION
MARCH  2014
IN V EST M EN T INSIG H TS FRO M LY XO R AS SE T M AN AG EM EN T
WHAT DETERMINES THE ASSETS HELD BY
YOUR ETFS?
ESMA’s rules set a minimum level of quality for the asset
basket held by any UCITS* fund. Notwithstanding ESMA’s
guidelines, Lyxor AM risk department has established a
set of internal rules that substantially exceed the minimum
regulatory standards. This ensures that investors in any
synthetic Lyxor ETF benefit from assets of high quality.
Our internal rules set minimum qualitative and quantitative
standards – such as observed liquidity, credit rating, issue
size or market capitalisation – for assets to be eligible
for inclusion in a fund. To minimize correlation risk,
in Lyxor ETFs tracking equity indices we will only
allow equities to be used as fund assets. In bond
ETFs, only bonds are permissible as fund assets.
It’s worth noting that the majority of our equity ETFs is
PEA-eligible. As a result, by design these funds invest
a minimum of 75% of their assets in equities issued by
companies domiciled in European Union member states,
Norway, Iceland or Liechtenstein.
LYXOR ASSET MANAGEMENT’S RISK DEPARTMENT
IS ALSO IN CHARGE OF ANALYSING INDICES’
LIQUIDITY. WHAT DOES THIS INVOLVE?
Before permitting the issue of a new ETF, we
conduct a preliminary study into the liquidity of
the index that is due to underlie the new fund. Once
the liquidity of the index is confirmed, the fund can be
launched. We check the free float of index constituents
and conduct regular studies to assure ourselves of the
index’s liquidity, whether the benchmark is acting as the
underlying for a physically replicated or synthetic ETF.
In addition to reviewing the index, we conduct analyses
of asset and collateral quality and of fund counterparties.
As a result of these tests, we sometimes decide not to try
and replicate a particular index (for example, the VSTOXX,
which measures the implied volatility of the Euro STOXX
50 index, derived from the options market).
WHAT DIVERSIFICATION RULES ARE IN PLACE
FOR LYXOR ETFS?
Again, we apply rules to fund collateral that exceed
the minimum diversification rules in place for
UCITS funds. Lyxor has established criteria for sectoral
and geographical diversification; in bond funds these are
also combined with controls on issuer quality. In respect
of funds’ diversification requirements, Lyxor sets minimum
standards that are among the most stringent in the ETF
market.
USING A SWAP MEANS INCURRING RISK
EXPOSURE TO THE COUNTERPARTY. WHAT IS THIS
RISK AND WHAT CAN BE DONE TO MITIGATE IT?
Regulations limit the risk exposure of a UCITS to a single
derivative counterparty at a maximum of 10% of a fund’s
assets. In Lyxor Asset Management’s ETFs transactions
take place with a single derivatives counterparty, therefore
limiting the overall risk of this type to 10%. Lyxor has a
policy to reset derivative-related counterparty
exposure daily so that it reaches a maximum of 0%
of a fund’s assets (i.e., so that any residual balance due
under the swap contract is in favour of the fund, rather than
the swap counterparty).
WHAT ARE YOUR PROCEDURES IN THIS AREA?
Lyxor’s risk department
has established a set
of internal rules that
substantially exceed
the minimum regulatory
standards.
Market movements result in variations in performance
between the index tracked and the ETF’s portfolio. If
the index produces a higher return than the portfolio of
assets, the ETF adds assets to its portfolio so that the
counterparty risk is reduced to a level below 0%. This
operation is conducted at least once a day, depending on
the markets’ volatility . In practice, each fund’s investment
team decides the daily procedure for reducing swaprelated counterparty to a level below 0%.
IS SOCIETE GENERALE YOUR SOLE SWAP
COUNTERPARTY AND HOW DO YOU AVOID
CONFLICTS OF INTEREST?
SG is only one of twelve counterparties with whom we
negotiate the terms of swap contracts. The financial
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EXPERT OPINION
MARCH  2014
IN V EST M EN T INSIG H TS FRO M LY XO R AS SE T M AN AG EM EN T
terms of each swap are fixed via a competitive, request
for proposal (RFP) bidding process that is conducted
by Lyxor. Lyxor thus works within an open architecture
framework, permitting us to transact swaps with any
approved counterparty.
The RFP process ensures that a fund is able to transact
at the optimal market price. If SGdoesn’t offer the
optimal rate on a swap and a deal is struck with another
counterparty, SG then steps in as intermediary between
Lyxor and the selected counterparty, while replicating the
third-party swap’s contract terms. We call this a “back-toback” trade.
Passing trades through SG in this way permits us to
concentrate and limit operational risk. The procedure
also allows us to apply generic control over our collateral
positions according to a single set of guidelines.
ETFS ARE COMPOSED OF SWAPS AND
SECURITIES THAT DO NOT NECESSARILY
CORRESPOND TO THE REPLICATED INDEX .
IF THE COUNTERPARTY WERE TO DEFAULT,
WHAT ASSURANCES DOES LYXOR BRING TO
INVESTORS?
We have described above our internal guidelines, which
set a framework for diversification, quality and liquidity of
the assets held by our funds. In addition to these controls,
we conduct two monthly stress tests.
The first stress test is designed to measure the
relative quality of the fund assets in comparison to
those in the index tracked by the ETF. We do this by
comparing the behavior of the fund’s asset basket and
the behavior of the index basket during extreme market
conditions. For example, if the Euro STOXX 50 index were
to lose 15% in value in a market event, the relative quality
Our internal guidelines
set a framework for the
diversification, quality
and liquidity of the assets
held by our funds.
stress test would allow us to assess whether a Euro STOXX
50 ETF is subject to equivalent, lesser or greater losses.
If the ETF’s asset basket declines less than the index, we
conclude that the ETF’s assets are superior quality. This test
helps validate the appropriateness of our guidelines, since
we are measuring the risks taken by the fund in a coherent
way. This is one of the strong points of our approach.
Lyxor also conducts a second stress test across all
our ETF portfolios, measuring the behaviour of those
funds’ assets and comparing it to that of the indices
tracked. As a reminder, if the counterparty defaults,
investors find themselves exposed to the ETF’s assets.
We have already implicitly addressed the question of
correlation by a judicious selection and allocation of assets
within each ETF with respect to the index tracked. This expost stress test helps us check that the funds’ assets are
really correlated to a high degree with the indices being
tracked. The objective is to maintain a consistent risk profile
for the investor in a fund in case of a counterparty default.
WOULDN’T WORKING WITH ANOTHER CUSTODIAN
THAN SOCIETE GENERALE SECURITIES SERVICES
HELP REDUCE THE POTENTIAL LINKAGE TO THE
SWAP COUNTERPARTY AND THEREBY REDUCE
CONTAGION RISK?
Currently, Societe Generale Securities Services is the
custodian for all our funds’ assets. In France, the segregation
of clients’ assets at a custodian is not just a contractual
duty but a legal requirement. The client assets held by the
custodian carry no risk exposure to Societe Generale, save for
the operational risk that might arise if the swap counterparty
defaulted. In turn, this risk is limited by France’s law on bank
insolvency, which provides for the continuation of essential
bank activities in the case of a default. At present, we do
not observe any counterparty risk to Societe Generale
as a result of the choice of custodian for Lyxor’s funds.
LYXOR ASSET MANAGEMENT ALSO OFFERS
PHYSICALLY REPLICATED ETFS AND USES
SECURITIES LENDING. HERE, RISK EXPOSURE
TO COUNTERPARTY IS ALSO POSSIBLE. HOW DO
YOU PROTECT INVESTORS AGAINST IT?
Since 2013, ESMA’s guidelines have imposed more
precise limits on the types of risks that result from
securities lending within UCITS*. In general, ESMA’s rules
resemble those typically used when a collateral portfolio
is invested. Lyxor’s internal rules for collateral are similar
to those regulating the investment policy for our funds’
assets, as described above.
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EXPERT OPINION
MARCH  2014
IN V EST M EN T INSIG H TS FRO M LY XO R AS SE T M AN AG EM EN T
Furthermore, Lyxor has decided to limit securities
lending on a daily basis to 25% of a fund’s assets.
This is a tighter constraint than ESMA’s counterparty
exposure limit in securities lending operations (the
exposure to any single issuer as a result of securities held
within a collateral basket may not exceed 20% of a fund’s
assets
As far as the revenue derived from securities lending
is concerned, our practices conform with ESMA’s
requirement to credit all income, net of direct and indirect
operational costs, to the UCITS*. The expert in all modern investment techniques
Lyxor Asset Management, a subsidiary of Societe Generale Group,
was founded in 1998 and counts over 600 professionals worldwide.
Lyxor manages $108.9bn* of assets, as the expert in all modern
investment techniques: ETFs & Indexing, Alternative, Structured,
Active Quantitative and Specialized Investments.
Backed by strong research teams and leading innovation capacities,
Lyxor’s investment specialists customize active investment solutions
optimizing performance and risks across all asset classes.
* USD 108.9bn - Equivalent to EUR 80.6- AuMs as of January 31th, 2014.
* A UCITS may not invest more than 5% of its assets in eligible securities
or money market instruments issued by a single entity. This 5% limit may
be increased to 10%, so long as the investments exceeding the 5% limit
do not represent more than 40% of the fund in aggregate.
This material and its content are confidential and may not be reproduced or provided to others without the express written permission of Lyxor Asset
Management (“Lyxor AM”). This material has been prepared solely for informational purposes only and it is not intended to be and should not be considered
as an offer, or a solicitation of an offer, or an invitation or a personal recommendation to buy or sell participating shares in any Lyxor Fund, or any security
or financial instrument, or to participate in any investment strategy, directly or indirectly. It is intended for use only by those recipients to whom it is made
directly available by Lyxor AM. Lyxor AM will not treat recipients of this material as its clients by virtue of their receiving this material. This material reflects the
views and opinions of the individual authors at this date and in no way the official position or advices of any kind of these authors or of Lyxor AM and thus
does not engage the responsibility of Lyxor AM nor of any of its officers or employees. Services and marks appearing herein are the exclusive property of
SG and its affiliates, as the case may be. Services and marks appearing herein are the exclusive property of Lyxor AM and its affiliates, as the case may be.
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