By Deirdre Brennan
After an ugly 2005, hedge fund experts declared convertible arbitrage all but dead, saying that the field was too crowded and opportunities were far and few between. While October returns for the asset class were weak (up 0.76%, according to the Dow Jones Hedge Fund Indexes), convertible arbitrage managers posted the best results for the third quarter, 3.27%, and the strategy is up 9.51% year-to-date, making it second-highest performer in the Dow Jones indices.
While some are skeptical as to the possibility of a return to the heady days of convertible arbitrage funds generating returns in the high teens, experts say that, despite a low-volatility environment, the asset class still has teeth.
Elliot Bossen, chief investment officer of Chapel Hill, N.C.-based Silverback Investment Management, a hedge fund that specializes in convertible arbitrage, remains bullish on the strategy.
“The market is not cheap, given where volatility is,” Bossen says. “But, if volatility increases, valuations increase, and when volatility is low you have a lot more scope for volatility to increase than to go down, so the risk-reward here is actually very good.”
Bossen, whose firm made it through the dark days of 2005, when a record number of convertible arbitrage shops shut their doors, says that investors need to take a long-term view on the strategy, which has consistently performed well over the vast majority of the last 20 years.
“The key to success in convertible arbitrage is to always be invested, because convertible arbitrage is a strategy that protects you from tail events and is a diversifier to your portfolio,” says Bossen. He explains that since valuations can only be squeezed so far, successful investors in the strategy know how to increase their allocation during the dislocations.
“Over the long-term, the only investors who have done poorly by making allocations to convertible arbitrage are those who abandoned the strategy during troughs in performance,” he says.
According to Bossen, there are three ways to make money in convertible arbitrage: First, when the overall market is cheap, second, when volatility and credits are improving and third, by finding individual idiosyncratic positions.
“A good convert manager can go out and find those securities that make sense to own because they have alpha in them,” he says. “Right now there are lots of individual alpha situations to invest in, with the kicker that additional profits can be attained if volatility increases from these very low levels.”
Victor Park, director of New York-based fundraising firm Alternative Asset Investment Management, is somewhat more tempered in his outlook.
“It will always have its place in a portfolio, and it is coming back,” he says, “but that is because we've had a torrid pace of deals based on earnings growth through acquisition strategies… that’s why the event guy is doing well.”
On convertible arbitrage, Park adds, small- and mid-cap converts present the best opportunities and seem to be getting overlooked by the asset allocation community. More specifically, Park points out that the bulk of the new issuance has been overwhelmingly in small- and mid-cap converts.
“People forget, certainly throughout the ‘90s as well as historically, that most convertible bond trading occurred in the small- to mid-cap space,” he says. “It is here where a skilled manager can find true inefficiencies, whereas in the large-cap space, with prop desks and multi-strats doing it opportunistically, combined with dedicated convert managers covering the entire universe, most large-cap convert managers are simply making directional bets in credit, volatility and/or interest rates.”
Others are bullish on the strategy as well, such as Investcorp, which last week added Silverback to its single-manager hedge fund platform. Ibrahim Gharghour, co-head of asset management at the firm, said in a statement, “We are long-time investors in convertible arbitrage strategies and find this space offers attractive investment opportunities.”
So for the skeptics, Bossen advises that they look beyond the negative hype.
“In the past twenty years we have seen brief periods of underperformance from convertible arbitrage–whether due to LBO scares in the ‘80s, rapidly increasing interest rates in 1994, or the dramatic decline in volatility in 2004-2005,” he says. “But once we get past those things it reverts to the mean, and in the long-term convert arbitrage contributes excellent risk adjusted rates of return.”