As investors agonized over whether markets were in a bear of bull rally, money continued to be made by hedge funds. Let’s look at the 1 month numbers. Equity long short returned a strong 5.74% on the back of rising equity markets. They captured roughly half of the upside in equity markets. That’s not the idea, but that’s how it is, particularly with aggregates. Convertible arbitrage also had a good month, up 5.74% as a confluence of technicals and fundamentals led a general recovery in convertible bonds. The convertible bond market was one of the most distressed markets in 2008 and is now understandably seeing a strong recovery. Emerging market hedge funds also one of the most distressed markets last year did exceedingly well in April, up 7.80%. As one might expect, the strategies that did well last year, Global Macro, CTA’s and Merger Arb lagged not only in April but YTD. Taking a slightly longer term view (backwards), over 12 months, Global Macro and CTA’s did well, so did Merger Arbitrage and Market Neutral. Emerging Market funds are still well under water, so too Convertible Arbitrage and Distressed  Securities.

So much for the rear view mirror.

The past 2 years will be the some of the most heavily analysed and misunderstood periods in the history of investing. The analysis of the errors and weaknesses of this period will help us to avoid repeating the mistakes we made, but the human being is creative and it is almost certain that new mistakes will be developed and implemented.

In the meantime, the performance of index aggregates is interesting albeit not terribly helpful in investing for the future. There is some evidence of momentum in returns in markets as well as in some strategies, but there is insufficient consistency that one can mechanically act on simple momentum indicators.

You’re performance is lagging the market. Maybe you are only up single digits or mid teens, ytd. The (MSCI Asia-ex Japan) market is +35%.

You panic because you’re getting left behind.(http://seekingalpha.com/article/140986-underperformance-angst-and-panic-to-the-upside?source=article_lb_author) You tell yourself, its ok, hedge funds are absolute return. But then how much did you make in 2008? You’re running a low gross maybe around 60% with a low net around 20%, chock full of defensives on the long-side and high beta crap on the short side. Beta adjusted you’re at best neutral. The markets keep rising. You tell yourself, it doesn’t make sense, fundamentals are still bad. Yet the market still rises and you lag farther behind. Then you ask yourself, do i bite the bullet, go super long and load up with all the stuff that has gone up 100% already, or do i stand firm? To chase or not to chase?, that is the question. The urge to follow the herd become unbearable. If I chase, and the market reverses, then I’ll be negative. If I don’t chase and the market rises more than I’ll be further behind. Welcome to underperformance blues. What was usually reserved for long only managers, is now creeping into their hedge fund counterparts psyche. (http://seekingalpha.com/article/140615-are-hedge-funds-missing-the-rally)

To that I say, play your own game. Who cares what the market does anyway? You shouldn’t be correlated with the markets. What’s the point of paying 2/20 for index returns? I would pull my money out of any hedge fund who is +35% this year. If you can churn out 15% year after year then you are a hero. Sticking to your investment process during tough times is the true test for any money manager. At some point every money manager has to go through this. Ask Warren Buffett during the dot.com craze. Resist the urge to follow the crowd, because if you don’t, you’re not worth the 2/20.

Convertible arbitrage has been one of the best performing hedge fund strategies year to date in 2009, up 17.9% while the HFRI general index has gained 4%. Recall, however, that convertible bond arbitrage was one of the worst performing strategies in 2008 losing 33% while the HFRI general index lost 19%. The losses came from a confluence of general risk aversion, deleveraging by banks and institutions, hedge fund redemptions and failures from over-levered portfolios, and a collapse in the funding mechanism. So acute was the risk aversion that convertibles were sold down regardless of issuer fundamentals or credit quality. Such sell-offs naturally create opportunities for the astute investor as idiosyncratic risk is mispriced by a market  on the one hand, and systemic risk is overpriced by the market on the other, in the midst of market panic.

It is natural therefore that once the acute and broad based risk aversion had reached its zenith, convertible bonds would represent exceptional value and rebound. The last 4 months have seen this occur in a reversion of the systemic risk trade. Convertible bonds have rallied across the board with demand coming from fundamental credit investors, hedge funds, corporates and issuers buying back their own bonds. Notably absent or at best much diminished was demand from bank prop desks.

For corporates, convertible bonds are an attractive means of funding. Issuers will balk at equity issuance at what many consider distressed equity valuations. Financials and Banks will continue to raise equity capital of course but for regulatory purposes. Corporates will find equity an expensive route to funding. Realized and implied volatility levels are such that convertible represent cheaper funding through selling equity at a premium and paying reduced rates of interest. US and European issuers have issued over 6 billion USD respectively year to Apriljabre. For issuers with the wherewithal, retiring existing debt trading at acutely distressed levels and refinancing with new issues is efficient balance sheet management. Convertible buybacks in the US alone amounted to some 7 billion USD in April alone and a total of 30 billion USD since 2H 2008.

For hedge funds, no longer do they face the volume of redemptions they faced in 4Q 2008 and the first couple of months of 2009. Greater predictability of their equity base has allowed them to restore their risk exposure. Moreover, while the financing mechanism hasn’t been fully restored, prime brokers are beginning to offer term financing for diversified portfolios of US and International convertibles.

The absence of bank prop trading in convertibles is an interesting theme. Bank prop demand was a major force in the convertible market pre crisis. Capital constraints have removed this important participant with interesting consequences. By reason of their size in the market, bank prop trading was a major competitor in the convertible market. The cost of funding for prop desks also put them at a relative advantage and also resulted in excess demand distorting issuance and pricing in the primary market.

One of the main concerns of investors has been liquidity in the convertible market. Liquidity is a fickle quantity. And yet, convertible markets have recovered a good deal of their liquidity since 2008. Liquidity is arguably better than in years such as 2005 when the hedge fund industry represented the large majority of demand for convertibles, for liquidity is more than demand or supply but a balance of both, and a diversity of participants on either side. Anecdotal evidence collected from my conversations with several convertible arbitrageurs suggests that most of their portfolios have become liquid to the point that even a large fund could liquidate their portfolios in a matter of days, if not a single day.

Convertible arbitrage also benefits from a diversity of applicable trading styles. While the distressed valuations at the end of 2008 suggested a glaring risk aversion reversal trade, the current market is replete with less-directional opportunities. These arise from the diversity of pricing and valuation across the convertible space, as well as a revival in primary issuance. The credit elements of convertible arbitrage were highlighted in 2008 and will continue to be interesting. Directional expressions of fundamental views on companies can be very efficiently captured using convertibles as well. A fundamental view on a company need not be restricted to first order (levels) but can extend to views about the cheapness of the volatility of the company. Capital structure trades can also be expressed with convertibles for example in theoretical replications with bounded jump to default values for a range of recoveries. The bottom line is that while somewhat complex, convertibles now represent good absolute value, good relative value, and value as a tool for expressing more esoteric arbitrage situations.

Should not a capitalist system punish as well as reward? We saw the devastation left by Lehman when it filed and concluded that some banks are too big or too interconnected to fail. But we had a sample size of 1. Are we sure that no other banks should be allowed to fail? An un-named bank recently hired someone and paid him pre-crisis levels of pay. They did that with government money. Because of that, I find it hard to hire the same calibre of people at lower prices which one would imagine would be the case with all the lay-offs. The Great Rescue has distorted market pricing of labor in this instance, but also has distorted the price of money and of risk, a far more important mispricing. So with the Fed unilaterally setting short rates, with Tarp and Talf and the legacy loan program in action, what is price of money, RMBS, CMBS? In a general equilibrium world, what is the price of a hamburger, given that we are uncertain about the price off credit and money?

Save the patient, has been the justification for the various bailouts. But the patient is still on life support. And at what point, and who determines that point, at which life support is no longer necessary?