Two fundamentally opposed views on hedge fund performance are going head-to-head. According to one, convertible arbitrage is a hedge fund strategy that is a victim of its own success: record inflows to the strategy over the past few years has depleted its potential for good. According to the other view, we’re just going through one phase in a cycle.
The money follows the argument. With convertible arbitrage hedge fund indexes showing year-to-date losses ranging from 5% to 9%, some investors are swearing off convertible arb. Unusually heavy redemptions are still going on but are expected to peter out by the end of the second quarter.
For others, such as institutional investors and funds of funds, this represents a buy opportunity. Assets had grown too much in response to earlier strong returns, they argue, so as the hot money leaves, the downward pressure on profits may ease.
Convertible managers tend to concur with the cyclical view. Philip Taylor, manager of Carisbrooke Investment Management in Short Hills, New Jersey, describes a long-term process where supply and demand shift over time, creating temporary imbalances. Returns rise and fall with these adjustments.
Global experience shows this pattern, he argues. In periods of excess demand, he says, convertible bond prices are high, so there is an increase in issuance by companies. Growing supply then buoys returns.
Volatility is a key factor, both in general and in recent performance. Falling volatility can destroy returns but can also create a better opportunity for entry. When that happens, demand starts to push prices up. In time, higher prices encourage more issuance, liquidity rises, and returns recover. At some point supply will exceed demand, and returns will start to fall again.
Skilled managers can adapt to changes along this slow-motion rollercoaster. Volatility decreased in 2003 while high-yield bonds offered attractive profits. Managers who shifted from volatility trades to credit trades did well. Others did not adjust and performed poorly. To achieve solid returns in the long run, managers in convertible arb need to be generalists, Taylor says, and alter their orientation as conditions change.
If you accept that what goes around comes around, this is a good time to invest because prices are attractive. Taylor expects that redemptions will reverse, in part because convertible arbitrage fills an important need in hedge fund portfolios: It is negatively correlated to other strategies, making it a natural hedge.
Perhaps the most enlightened discussion of the prospects for the strategy going forward appear in FrontPoint Partners’ most recent quarterly investment research. In “Time Horizon Disintermediation and the Convertible Bond Market,” Michael Litt remarks that longer-term investors who have the experience to view the strategy’s recent performance in a broader historical context will provide new capital inflows as the less experienced hedge fund investor exits.
“It is likely that the convertible arb strategies that attract capital from this longer-time-horizon group of investors will have different structural characteristics. These will likely involve lower leverage and a greater tolerance for some of the . . . credit and equity directional risks. Another factor will be the return of equity volatility toward the midpoint of its historical range, which will once again draw in a greater breadth of issuers to this market. There is a role in the market for an asset class that allows corporations to monetize the volatility of their equity securities, a role unlikely to disappear.”–Chidem Kurdas and Jeff Joseph
Chidem Kurdas is HedgeWorld’s New York bureau chief; Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.
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