Brave the World of Hedge Fund Investing

Physician's Money Digest, August15 2003, Volume 10, Issue 15

Recently, an increasing number of high-net-worthinvestors have been rerouting portionsof their portfolios into hedge funds(ie, a fund that can take both long and short positions,use leverage and derivatives, and invest inmany markets). Even conservative institutional investorswho previously shunned theseprivate partnerships are now embracingthe asset class. According to a Gollin/Harris Ludgate survey, hedge funds arenearing the investment mainstream.

There are currently more than 5000hedge funds. These funds encompass awide array of investment strategies andrisk elements. They typically employ avariety of arbitrage (ie, profiting fromdifferences in price when the same security,currency, or commodity is traded on2 or more markets). Among the lowervolatility hedge fund strategies, convertiblebond arbitrage is 1 of the more consistentstrategies.


Convertible bond arbitrage involves purchasingconvertible securities (ie, corporate fixed-incomeinstruments with an embedded equity option) andhedging them by selling a predetermined amountof the equity. Investors may exercise the embeddedequity anytime, converting the bond into equity.

Convertible bond arbitrage funds'investmentrisk is analogous to a US Treasury fixed-incomestrategy, with returns comparable to a conservativeequity strategy. According to the CSFB/Tremont Arbitrage Index, the 5-year averageannual return for convertible bond arbitrage forthe period of 1998 through 2002 was 10.6%,with a 5-year total compounded return of65.46%. Annualized volatility for convertiblebond arbitrage during this period was just 5.49%.

The 2 primary drivers in the convertible bondarbitrage market are volatility arbitrage and creditarbitrage. Volatility arbitrageurs attempt to capturethe price differences between impliedand historical volatility, relying on theconstant movement of the underlyingequity to provide opportunities forreducing or intensifying their hedges.

When the global economy worsenedand credit spreads widened (ie, the differencebetween S&P 500 investment-gradeAAA bonds and speculative orhigh-yield bonds), volatility arbitrage fellout of favor. Arbitrageurs shifted theirstrategy from volatility to credit andtried to pick excess capital, or "alpha."

Many of these arbitrageurs didn'thave experience evaluating credit andwere unable to discern whether issuing companieswere default risks. They tried to mitigatetheir risks by buying credit default swaps, whichostensibly remove underlying risk by swappingout an issue's credit to an investment bank. Banksare free to write credit protection for any numberof buyers, and can conceivably write protection inexcess of a convertible issue. This excessive leverage,a potentially dangerous practice, could havenegative ramifications for investors.

When credit spreads reached an all-time high(ie, 1574 basis points) in October 2002, creditarbitrageurs just starting out found themselvesunable to take advantage, primarily due to theirreliance on credit default swaps, which failed totake into account that spreads could widen withouta default actually occurring.

Experienced convertible arbitrageurs knowthat digging into and analyzing an issuer's financialsis preferable to the indifferent practice ofbuying credit default swaps. There is no substitutefor face-to-face meetings or participation inquarterly conference calls with the managementof issuing companies.


The underlying theme in today's marketplace isrefinancing and restructuring. Companies are findingit increasingly cheaper to fund their activitieswith convertible bond issuance. The proceeds fromrefinancing are being used to reduce outstandingcompany debt—more often than not their convertiblebond debt. Arbitrageurs experienced withthese mispricings are best positioned to benefit.

There are many databases and benchmarkingservices that can provide a comprehensive overviewof long-term performance by fund managers.Physician-investors should pay particular attentionto 12-month rolling volatility. Managers displayinghuge monthly gains are also likely to absorb comparablemonthly losses. Convertible bond arbitrageshould deliver consistency, and monthly performanceshould not display wide variance.

Convertible bond arbitrage is a complex, multilayeredstrategy, and while volatility and credit areimportant aspects of the convertible universe, thereare many other aspects that contribute to steady,risk-averse performance. Conservative investorswill likely feel more comfortable with fund managerswho offer a more diverse approach, whichcalls for greater research, analysis, and experience.Their reward will be consistent, conservative, long-termperformance with measured risk.

Andrew Pernambuco

is a principal at Alexandra

Investment Management

in New York,

NY. He welcomes questions

or comments

at 212-301-1800 or