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?

Star Date 2009 05 19:

Hedge funds have been accused of missing the equity market rally begun March 2009. Let us look at an example of an equity market such as the European equity markets to see why.

Equity markets are up year to date. The Stoxx 600 for example is up some 6% year to date after a 22% drop followed by a 37% rally. Yet it has been a very difficult market for trader and investor alike. Only the truly brave make big money (I am being polite.)

Sentiment worsened almost linearly and certainly monotonically since September 2008 to March 2009. Then suddenly equity and credit markets turned and rebounded sharply. By late April, commentators began talking about ‘green shoots’ of growth and recovery. I guess even a dab of moss after a nuclear Winter counts as green shoots. Equity markets have behaved erratically. Cyclicals led the rebound, defensives lagged it. This is typical of late stage recessions and recoveries, yet fundamentals are far from healthy. Markets, however, are driven by fundamentals only until they are driven by psychology. Healthier is sufficient, the market doesn’t need healthy. The Q1 results season has been interesting. In a normal recession, analysts adjust their earnings forecast slowly, exhibiting serial correlation. As a result, companies tend to miss their forecasts and the street then engages in a staged downward revision leading to more and more disappointment. So violent was the shock to the financial sector, repository of stock analysts that earnings forecasts were cut almost indiscriminately. The rebound therefore was set up well in the 4Q 2008 as sentiment drove forecasters to overshoot. In the ensuing rally, low quality companies have outperformed high quality companies and market breadth simply isn’t there. Its not a healthy rally, but shortsellers beware, it could well become one.

Within the Stoxx 600, the sector dispersion is high. In the last 3 months, banks, insurers and financial services outperformed. The rest of the sectors cluster quite closely. Telecoms, utilities and healthcare underperformed. Dispersion is moderate with the exception of the banks. The Stoxx Bank Index rose 48% in the last 90 days in spite of the chronic uncertainty over their solvency and profitability. Guilt by association buoyed Insurers to a 26% gain over the same period. Consumer cyclicals made gains in the high teens. In the same period, Telecoms lost 4.25%, Healthcare lost 6.66%. Getting the sector call wrong would be costly.

Within each sector, dispersion was fairly moderate with the exception of banks and resources. Dispersion in the banking sector in Europe was very high. Ironically, it seemed that poorer quality banks or banks at risk were the better performers while the higher quality, diversified and stronger banks lagged. Some of this was of course for the fact that we are measuring performance from 3 months ago. If we go back further in time, the market is not so silly after all. In insurance and financials, dispersion is also high. Why is this? Is it because investors are more discerning? But how can they be given the opacity and lack of clarity over the financial strength of banks, insurers and financials? If these sectors are being traded as a risk premium trade, should not the dispersion be a lot less? An additional clue comes from the auto sector where dispersion is also high. What do autos have to do with banks, insurers and financials?

If we rank the dispersion of stocks within sectors by sector, we find the greatest dispersion in banks, then autos, then insurers. Then comes the average for the Stoxx itself. The other subsectors come in below the average. That is how stark the skew is. The dispersion of industrials, basic resources, oil and gas, consumer goods, utilities and telcos all exhibited low dispersion, in effect behaving as blocs.

One would have expected that sectors in which there was greater visibility of earnings, where there was less uncertainty of cash flows, would allow the stock picker the opportunity to be more discerning and to then introduce pricing dispersion. Instead we have found pricing dispersion in the sectors with the least transparency, the least clarity, and the least certainty with respect to earnings, cash flow, or financial strength, sectors which if anything, should have been priced as a bloc, and on a risk basis. Why is this?

In these confusing times, it pays to be careful. Market commentators who criticise investment managers for missing out on the massive equity market rally should realize that there are grounds for caution. When in doubt, reduce risk. In the high dispersion sectors where fundamentals are unclear, a low gross or tight stops is a good idea. Preferably a low gross. In the low dispersion sectors where fundamentals are clearer, a higher gross or wider stops is a good idea. You capture some of the upside, but you won’t pick up a large chunk of i
t. If you did, should you worry?

Hedge fund investors are gluttons for punishment. So says the economist in their May 14, 2009 article where they claim:

1. That hedge funds spectacularly failed to achieve the absolute returns that were supposed to justify their high fees. 
2. That hedge funds ran liquidity mismatches between the assets in their portfolios and their volatile funding and investor terms. 
3. That hedge funds suspended redemptions or gated investors attempting to redeem. 
4. That funds of hedge funds were only marginally less useless than Madoff’s auditor.
5. Yet, says the Economist, a recent survey of most of the world’s big hedge fund investors conducted by Goldman Sachs, suggest that investors remain surprisingly happy. Also there is anecdotal evidence that redemptions are slowing and that money is actually flowing back into the industry. 
6. The Economist also finds that there does not appear to be much appetite to reform the structure of hedge funds. They also point out that there is scepticism or at least a tepid take up of managed account structures. 
7. The Economist finally suggests that hedge funds will slowly but surely become more like the old-fashioned asset managers they once threatened to usurp.

Lets deal with the charges. 

1. Hedge funds did indeed fail to generate absolute returns in 2008. But was the playing field a level one? From Dec 2007 to June 2008, hedge funds were almost flat, the HFRI Index returning -1.6%. Once Lehman collapsed and bans on shortselling were established, once FNMA and FRE were bailed out arbitrarily within  their capital structures, hedge funds’ losses accelerated resulting in a return of -19% for 2008. Long only equity indices, credit indices, commodity indices, real estate indices would have lost between 30 – 45% for the year. 
2. Some hedge funds did indeed run liquidity mismatches between their assets, their funding and their equity bases. Macro hedge funds and equity strategy managers did not have this problem. However, barriers to entry were low in the last few years leading to a proliferation of mediocrity, to a contamination from long only mindsets and expertise and thus correlation of industry aggregate indices to long only indices. A good hedge fund manages the downside as much as the upside. Examples abound of managers who have protected capital in the turmoil suggesting again the importance of due diligence and manager selection. As for downside from illiquid positions, this afflicted mostly the special situations, mezzanine finance, quasi private equity strategies which while historically at the fringe of hedge funds had gained popularity in the last few years.
3. Suspensions and gating. Guilty as charged. Some strategies cannot be run in open ended hedge fund format. They require lock ups and in some cases they just need a closed end fixed term self liquidating vehicle. However, once an ill structured investment vehicle has been hit in the crisis of 2008, there are basically 2 choices to be made. 1. Liquidate to meet redemptions, liquidate at all cost, even at firesale prices, and 2. Suspend redemptions and undergo an orderly liquidation. The devil is in the details and the behavior of the manager in such a liquidation. It is hard to swallow that a manager continues to charge fees of any kind during a suspension or liquidation. Open and frank communications are also in order in a liquidation. And next time, if there is a next time, if you want to stick illiquid assets into a portfolio, let investors know before hand and structure the investor vehicle to lock in the equity capital and the financing. Otherwise, get ready for some misrepresentation suits. 
4. Funds of funds are of  varying quality. One broken down car doesn’t mean that all automobiles are unreliable. More importantly, funds of funds serve specific purposes. They are provide a service not only to the investor but to the hedge funds as well. For a more detailed treatment of see my earlier article The Future of Funds of Funds. 
5. Why do investors remain relatively happy with hedge funds? Look at the numbers. Sure, hedge funds didn’t exactly do what they said they would do in terms of protecting capital in the midst of one of the worst financial crises in recent history. But they would have lost only half of what they would have lost had they been long only. Investors are only reacting rationally. 
6. That there does not appear to be appetite to reform the hedge fund industry is disturbing because for all the outperformance of hedge funds versus traditional and other alternative investments, the hedge fund industry is in need of reform. Hedge funds terms and structure are not always optimal for the strategy; often they are driven by what sells, in other words, what investors want. How ironic is that. Investors have always wanted more liquidity than the portfolio could bear. Hedge fund managers pandering to investors gave them what they wanted. Standards of transparency and clarity and alignment of interest need to be addressed. While there has not been much visible activism in terms of reforming hedge fund terms and manager behavior, witness CalPers new policies for investing with hedge funds. Also, the near halving of assets under management in the industry from some 2 trillion USD to 1 trillion USD over the last 2 quarters is evidence of investors policing the market. 
7. Will hedge fund managers come to resemble old-fashioned asset management companies? I hope that hedge funds become more accessible to investors of all types. Including retail. More choice can only be better. Of course intermediaries will be required to manage the added complexity of hedge fund strategies, and here funds of funds are challenged to step up to the plate. I hope that hedge fund techniques of investment become more mainstream and widespread. Leverage and short selling can only improve market efficiency. I hope that hedge funds find traction among retail investors as much as sophisticated ones. Hedge funds have proven their worth in 2008 relative to other investments. And retail investors by reason of their size and numbers represent a more predictable and stable asset base and are therefore good for  the stability of hedge funds. 

The hedge fund industry has come under considerable fire since the financial crisis of 2008. The reasons, however, are many, and complex, and in some instances are justified and in some, not. For those of us who have invested in hedge funds, we have been encouraged by some and disappointed by others, but by no means have we lost faith in the industry as a whole. Most of us would like to help the industry grow and develop to be stronger and more investor and market friendly. Some of the blame does fall on the hedge fund manager, where they have been arrogant, stubborn or self serving, some of the blame must go to the regulators for legislating before understanding, but some of the blame is the investors’ as well, where they have been ignorant, negligent, lazy, or behaving blindly as a herd. Most of all, the hedge fund industry suffers from  a PR problem, as will any industry which is inherently complex. Unfortunately, so many features of this industry cannot be overly simplified, try though the mainstream press might.