Martin Steward meets a manager offering an unusual combination of small-cap and absolute-return option strategies

Frankfurt-based Lupus Alpha Asset Management - co-owned by its partners and a family office and, with €6.5bn under management, one of Germany's biggest independent investment managers - certainly boasts enough firsts to justify its ‘leader of the pack' name.

As well as launching the first locally-domiciled German single-manager hedge fund in 2004, shortly after setting up in 2000 it rolled out the first pure-play SMAX/SDAX fund (Smaller German Champions), and 2006 saw it start the first European micro-cap fund (Micro Champions), and Continental Europe's first ‘Talent Hotel' for start-up hedge fund managers, which currently supports four strategies.

The firm innovates because it is supremely focused. Virtually all of its strategies fall into two categories - small and mid-caps (SMID) and absolute return - that balance one another nicely.

It was clear from the start that Lupus Alpha's chosen specialism, smaller companies, could be a wild ride: within weeks of Smaller German Champions and Smaller Euro Champions rolling out, the dotcom bust led to one of history's worst stock market crashes on the Neuer Markt (and its closure by Deutsche Bourse). That led to a great buying opportunity in German small-caps, of course - but it also meant that Lupus alpha did not launch another SMID product until its Europe-wide Micro Champions fund in 2005.

Ninety-five percent of the firm's clients are German institutions, from large CTA pension funds to family offices - an investor base not known for its hunger for risk. Recognition of this fact led to the 2008 launch of the All Opportunities fund, a European SMID strategy with an absolute return objective. Balancing a bucket for 10-12 high-conviction stocks (as opposed to 60-70 in its standard SMID funds) and another for special situations (micro-caps and IPOs) with a third bucket focused on long/short pairs trading, the portfolio limits its market exposure to 25% net long. That limited 2008 losses to around 15% and enabled good participation in the rebound (it finished 2010 with an annualised return since inception of more than 12%).

"The main client area is smaller family offices that like our long-only small and mid-cap process but don't have the risk budget for it," says managing partner Ralf Lochmüller. "We are surprised not to have seen more growth in small and mid caps. We often hear about the ‘lost decade' for equities, but if you held small and mid caps from 2000 onwards you'd have achieved 7% annualised returns. The fact is most institutional investors have been reducing their equity allocations and for a long time they have been telling us about the pressure they are under to control short-term volatility. As such, they needed an asymmetric risk profile in their investments - but you can't really build that without using derivatives."

And on that score, the Investment Modernisation Act of 2004 changed the landscape, opening the door for locally-domiciled Spezialfonds running derivatives-based hedge fund strategies.

Lupus alpha had anticipated the move for some time and hit the ground running having launched its Structure Invest and Dynamic Invest strategies in Q2 2003.

Structure Invest guarantees to limit losses during a single calendar year to -5% (it ended 2008 down 4.5%), and it does so by holding fixed income securities that are set to mature at year-end alongside an actively-managed portfolio of options strategies benchmarked against a simple bull index call spread or collar. That portfolio (of collars, but also other volatility and option time-value trades) maintains positive delta to the underlying DJ EuroSTOXX50 index with a defined upside and downside, enabling the fund to participate in the equity market while staying above 95% of the start-of-year NAV. In 2006 the firm expanded the idea in its Structure International fund, which adds to the basic options strategy the choice of European, US or Asian underlying markets.

After the loss of 2008, Structure Invest's positive delta meant that it could participate in the 2009 recovery - delivering an 8% return. This was not the case for Dynamic Invest, which has the same -5% calendar-year loss limit: it finished 2008 down 4.96%, but has since continued to see performance drift. Its story is an interesting illustration of the limits of downside-guaranteed strategies.

While Structure Invest's positions are net-long delta, their downside limits are absolute. Dynamic Invest's are not. This strategy began as the implementation of Lupus Alpha's single-stock volatility forecasting model: the core strategy is to sell single-stock volatility positions to profit from realized volatility coming in lower than implied. But to reduce the risk of that short-volatility position, the fund buys index volatility at the same time.

Those familiar with options strategies will note that this puts Dynamic Invest on the other side of the classic ‘dispersion' trader, who sells index volatility and buys single-stock volatility to profit from the diversification effect that usually makes the latter higher than the former. So while the pure delta-related downside of the fund's positions can be limited to -5% (just like Structure Invest's), once those positions have reached -5% this long-correlation exposure remains in place - so further losses cannot be ruled out. "For that reason, there is an additional element that tells us to de-invest the portfolio if we come close to the loss limit," says head of absolute return Alexander Raviol.

That is why Dynamic Invest has been unable to recover. It had to unwind positions in 2008, and was been unable to re-enter as implied correlation remained higher than realised throughout 2009-10.

"Considering we have other products that we prefer, we actively advised our clients to switch - particularly into Volatility Invest," says Raviol.

Launched in 2007, Volatility Invest pursues an active calendar-spread strategy in which short-dated index puts are sold while longer-dated puts are bought, to exploit the faster time-value decrease in the short-term options in the context of a positive spread between implied and realised volatility. For this strategy, it was evident from the start that a maximum loss limit would be impractical: despite the offsetting long-dated puts, it's short position in near-term volatility will hurt when equity markets go into a big seizure like Q4 2008. However, it can target an absolute return of EURIBOR+2.5%, because losses from short-term volatility spikes will inevitably be followed by big recoveries as the fund profits from the short-dated puts that it sold at the top of the market for volatility.

Those eight years of (sometimes difficult) experience building risk-controlled options strategies will culminate in Lupus Alpha's latest offering, due for launch before the end of this year, says Raviol. "The new fund will combine everything we know and do in volatility markets: index and single-stock; long- and short-vol; systematic and discretionary. It will also have an absolute return objective of positive numbers every calendar year."

By then the absolute return team will have grown from 16 to 21, alongside the nine who manage the SMID products. In its well-defined niches, Lupus alpha continues to lead the pack and find plenty of scope for growth.