Monday, 26 October 2009

CB Arbitrage - is it becoming Institutionally Uninvestable?

In 2003 convertible bond arbitrage was a core hedge fund strategy. Everyone who invested in hedge funds invested in CB arb funds. There had not been a down year for CB arb funds since the year of the LTCM crisis, 1998. On an index basis CB arb had produced positive returns in 8 of the previous 10 years up to 2003, and in the positive years the returns were in the teens. It was indicative that 2003 was the year that a successful arb manager had a book about his strategy published. Nick Calamos of Calamos Advisors, LLC ran one of the largest firms utilising the CB arb strategy, and Wiley published his zeitgeist-capturing title “Convertible Arbitrage: Insights and Techniques for Successful Hedging”.

As a proportion of the capital invested in hedge funds convertible bond arbitrage peaked in May 2003. At that point CB arb funds constituted 8.4% of the (asset-weighted) benchmark Credit Suisse/Tremont Hedge Fund Index, having been less than 3% of the industry assets in 1997. Clearly CB arb funds had drawn in investors’ capital - a lot of it. According to Tremont Advisors, convertible arbitrage total market value grew from just $768m in 1994 to $25.6bn in 2002 – this gives a growth rate of 50% on average per annum.

The capital flows were the consequence of the returns generated, and were to become the source of the decline of the convertible bond arbitrage strategy. The 2003 CB arb index returns of nearly 13% were enough to draw in more capital in 2004, a result of the usual lag between returns and allocations. But 2004 returns from the strategy were disappointing – some managers were down a little bit and most were up a small amount. And, although the year began with four positive months in the strategy, there were only three positive months in the rest of the year. Investors began to withdraw capital from this “core strategy”.

In truly liquid strategies, with a multiplicity of participants in the particular market, redemptions will not hurt returns much. But the convertible market had become dominated by hedge funds by 2004. Some estimates had hedge funds conducting 90% of the trading in convertibles in 2004, and as most of their holdings are acquired swapped-out on issuance it is equally indicative that more than 70% of the convertibles issued in 2004 were sold to hedge funds. Hedge funds did not just have major influence on convertible bonds in this period, they were the market for convertible securities.

In the second half of 2004 the apparent value in the securities held by CB arb funds increased as their discount to their theoretical value widened a little. So the managers could make a case that their opportunity set was getting a little richer, but the signal event for the strategy arrived in 2005 to catalyse investor redemptions on a significant scale. General Motors had issued amongst the largest and therefore most liquid convertible securities in the market – they were widely held convertible bonds and a core position for CB arbs. Early in 2005 Kirk Kerkorian tendered for GM stock to increase his position in the company, and the arbs were caught short of stock. CB arb funds were fully invested (so leveraged) and had to sell positions to meet margin calls. In effect they created their own death spiral of forced position sales, lower marks, lower fund NAVs, and that led to more redemptions. There was no one else to buy their positions off them in any size.

In the sell-off climax CB arb losses were around 3% for the month of April 2005, though some funds lost several times that amount. Although CB arb funds had lost only 3% for the whole of calendar 2005, between May 2004 and May 2005 they put in ten down months and the perception of a strategy able to deliver steady double-digit returns to investors had gone. Investors fled from the strategy. Over the course of the 12-months from April 2004 to April 2005 the asset weighting of convertible bond funds in the industry went from over 7% to around 4%. Convertible bond arbitrage as a core hedge fund strategy was dead.

From the start of 2001 to March 2006 the average return of CB arb funds was just under 8 percent versus broader hedge fund average returns of nearly 12% over the same period. These returns were produced with a volatility of just over 4% for the average hedge fund and just under 4% for the average CB arb fund. Since then the characteristics of return of convertible bond arbitrage as a hedge fund strategy have changed again, in particular in the last two years.

Last year the Credit Suisse/Tremont Convertible Arbitrage Index was down 31.6% and this year is up 40.0%. The last eighteen months have been an extraordinary time in finance and markets. But even so, for a leading manager like Whitebox to have CB arb funds that were down 24% and 36% last year, only to be up by 56% and 73% in an arbitrage strategy is a challenge to the investor perception of the strategy. To the credit of the managers at Whitebox, at least these funds have NAVs at all time highs on the back of their performance this year. The same is not true for the average CB arb fund.

To reiterate these are arbitrage strategies. One definition of arbitrage is “a trading strategy that is used to generate a guaranteed profit from a transaction that requires no commitment of capital or risk bearing on the part of the trader.” Whilst the definition cannot be applied as written to modern financial arbitrage, still and all, investors in hedge funds have classified arbitrage strategies as coming within the relative-value category. Given appropriate risk controls, arbitrage and relative-value strategies should produce a return stream of steady consistent profits with blow-out protection for down-phases for the strategy. This should give a high percentage of winning months (more than 80%) with similar order profits and losses. These characteristics have not been present in CB arbitrage funds for some time.

It is no wonder then that as capital in the hedge fund industry has stabilised this year the proportion of the capital in the industry dedicated to CB arbitrage has continued to decline. At the end of September 2009 convertible bond arbitrage funds constituted only 1.77% of the asset-weighted Credit Suisse/Tremont Hedge Fund Index. This is not just a result of passive neglect, from net inflows going to other strategies. There have been net outflows from CB arb in each month in the first half of the year according to’s analysis, and anecdotal evidence suggests that has probably continued into the third quarter on balance.

Just as the publication of the “how to” book signalled the peak of the strategy, has Dow Jones signalled another shift for the CB arbitrage? In January this year Dow Jones Hedge Fund Indexes, Inc. announced that it has suspended publication of the Dow Jones Hedge Fund Convertible Arbitrage Strategy Benchmark, until further notice. The decision to halt publication of the benchmark was made jointly by Dow Jones Hedge Fund Indexes and the investment manager of the managed-account platform that supports the Dow Jones Hedge Fund Strategy Benchmarks. As a consequence, the investment manager took steps to reduce the platform's exposure to the convertible arbitrage strategy and to reduce the number of managers on the platform that specialize in this strategy. What does this action tell us?

So at less than 2% of industry assets a new query is raised on CB arbitrage as a strategy – how investable is it for institutional investors? Is it becoming a marginal strategy for investors in hedge funds on the basis of the amount of capital it is possible to commit? Is it just too volatile now to be a mainstream strategy in an era dominated by institutional flows?

CB arbitrage may be following the precedent set by merger arbitrage in the last ten years: it went from being a core hedge fund strategy to a minor hedge fund strategy. Then it became an elective component for opportunistic funds with a multi-strategy capability. Is it only a coincidence that the proportion of the industry’s capital invested in multi-strategy hedge funds has gone up by 40% in two years?

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