Brave the World of Hedge Fund Investing

SEPTEMBER 16, 2008
Andrew Pernambuco

Recently, an increasing number of high-net-worth investors have been rerouting portions of their portfolios into hedge funds (ie, a fund that can take both long and short positions, use leverage and derivatives, and invest in many markets). Even conservative institutional investors who previously shunned these private partnerships are now embracing the asset class. According to a Gollin/Harris Ludgate survey, hedge funds are nearing the investment mainstream.

There are currently more than 5000 hedge funds. These funds encompass a wide array of investment strategies and risk elements. They typically employ a variety of arbitrage (ie, profiting from differences in price when the same security, currency, or commodity is traded on 2 or more markets). Among the lower volatility hedge fund strategies, convertible bond arbitrage is 1 of the more consistent strategies.

SAFER HEDGE FUNDS

Convertible bond arbitrage involves purchasing convertible securities (ie, corporate fixed-income instruments with an embedded equity option) and hedging them by selling a predetermined amount of the equity. Investors may exercise the embedded equity anytime, converting the bond into equity.

Convertible bond arbitrage funds'investment risk is analogous to a US Treasury fixed-income strategy, with returns comparable to a conservative equity strategy. According to the CSFB/Tremont Arbitrage Index, the 5-year average annual return for convertible bond arbitrage for the period of 1998 through 2002 was 10.6%, with a 5-year total compounded return of 65.46%. Annualized volatility for convertible bond arbitrage during this period was just 5.49%.

The 2 primary drivers in the convertible bond arbitrage market are volatility arbitrage and credit arbitrage. Volatility arbitrageurs attempt to capture the price differences between implied and historical volatility, relying on the constant movement of the underlying equity to provide opportunities for reducing or intensifying their hedges.

When the global economy worsened and credit spreads widened (ie, the difference between S&P 500 investment-grade AAA bonds and speculative or high-yield bonds), volatility arbitrage fell out of favor. Arbitrageurs shifted their strategy from volatility to credit and tried to pick excess capital, or "alpha."

Many of these arbitrageurs didn't have experience evaluating credit and were unable to discern whether issuing companies were default risks. They tried to mitigate their risks by buying credit default swaps, which ostensibly remove underlying risk by swapping out an issue's credit to an investment bank. Banks are free to write credit protection for any number of buyers, and can conceivably write protection in excess of a convertible issue. This excessive leverage, a potentially dangerous practice, could have negative ramifications for investors.

When credit spreads reached an all-time high (ie, 1574 basis points) in October 2002, credit arbitrageurs just starting out found themselves unable to take advantage, primarily due to their reliance on credit default swaps, which failed to take into account that spreads could widen without a default actually occurring.

Experienced convertible arbitrageurs know that digging into and analyzing an issuer's financials is preferable to the indifferent practice of buying credit default swaps. There is no substitute for face-to-face meetings or participation in quarterly conference calls with the management of issuing companies.

THE BIG PICTURE

The underlying theme in today's marketplace is refinancing and restructuring. Companies are finding it increasingly cheaper to fund their activities with convertible bond issuance. The proceeds from refinancing are being used to reduce outstanding company debt—more often than not their convertible bond debt. Arbitrageurs experienced with these mispricings are best positioned to benefit.

There are many databases and benchmarking services that can provide a comprehensive overview of long-term performance by fund managers. Physician-investors should pay particular attention to 12-month rolling volatility. Managers displaying huge monthly gains are also likely to absorb comparable monthly losses. Convertible bond arbitrage should deliver consistency, and monthly performance should not display wide variance.

Convertible bond arbitrage is a complex, multilayered strategy, and while volatility and credit are important aspects of the convertible universe, there are many other aspects that contribute to steady, risk-averse performance. Conservative investors will likely feel more comfortable with fund managers who offer a more diverse approach, which calls for greater research, analysis, and experience. Their reward will be consistent, conservative, long-term performance with measured risk.

Andrew Pernambuco is a principal at Alexandra Investment Management in New York, NY. He welcomes questions or comments at 212-301-1800 or investor@alexandra.net.



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