Hedge fund arbitrage
Arbitrage is perhaps the most overused and possibly misunderstood word in alternative investing. Some would say that since hedge funds are in the business of identifying assets that are trading above or below their "correct" price, that every hedge fund is an arbitrageur. After consulting their dictionaries, others would say that arbitrage only applies when the same security is bought and sold SIMULTANEOUSLY with no residual risk. Some academic economists would claim there can be no such thing as arbitrage! But the best arbs are not easy to find or exploit and remain secret which creates barriers to entry.
A frequent analogy is that if a $100 bill is dropped in the street then it will be immediately picked up so therefore no easy money or arbitrages can exist or persist. BUT what if YOU are the person who picks the bill up? Someone will. What if you specialize in walking the streets 24/7/365 looking for likely drops? What if you spent some of your 2 and 20 fees on lots of employees to monitor lots more streets? What if you had the quickest technology and modelled the behavior of people so that you could identify, in advance, the streets likeliest to reap rewards. What if your execution costs are low enough that you can make a profit from picking up $10 or $1 bills. Even quarters? What if you monitored streets in locations no-one else had thought to look. As usual the academic market theorists are wrong. If you have the patience and resources to look for them, there are plenty of arbs in the markets just as money gets dropped in streets around the world every day.
Of course this can be taken too far and if the arbitrage becomes too well known or too tight and crowded it becomes hazardous. Arbitrages in the public domain will inevitably disappear. Nickels in front of bulldozers are incredibly dumb trades where newbie, brash traders and incompetent Nobel laureates risk the lives of their fund for 5 cents and end up getting crushed for billions. The arbitrages you want are $100 bills and no bulldozers in sight. Jim Rogers, formerly of Soros Quantum Fund, and who predicted the present commodities boom described the best trades as waiting until there is some easy money in a corner and just heading over and picking it up. He was right. Good arbitrages, like opportunities, are never signposted.
There are several hedge fund strategies classified as "arbitrage" of which equity statistical arb, merger arb, fixed-income arb, capital structure arb and CB arb are perhaps the most prominent. Some investors consider these to be "non-directional" which is unfortunate as there is almost always some directional dependence inherent in every strategy. But within these categories there is a vast difference in skill and ways these arbs are implemented. Probably only plain vanilla merger and CB arb are "arbed out" but even within those categories there is plenty of room for non-vanilla talent.
Lesser known but no less lucrative is systems arb. This is where a fund takes advantage of mispricings usually of fairly exotic derivatives and structured products. With the number of counterparty global investment banks quite low and all of them keen to be seen at the cutting edge of financial engineering, their different pricing models, software and assumptions can lead to anomalies and sometimes surprisingly wide differences of opinion. It can be as basic as different interpolations of interest rate, credit and volatility term structures. Even a few basis points adds up when leverage and optionality get thrown in. Some providers don't seem able to calculate correlation or dispersion correctly. More often however the "error" is much more subtle.
Another lesser known strategy is analyst and IPO arb. This is where a hedge fund manager uses a carrot and stick approach to make sure they are the "first call" on analyst rating changes and to get into lucrative IPO allocations. Often the carrot is paying higher than typical commissions and the stick is threatening to take their business elsewhere. There are a few "star" hedge funds around whose performance is NOT due to stock picking or trading ability but almost entirely due to analyst/IPO arb.
Some arb amounts to short selling the liquid and going long the illiquid. That usually works fine in a bull market for the underlying product but can get ugly when bearish times emerge. Some arb strategies have become so well-known that doing the opposite can make sense. Reverse merger arb is betting on an announced deal NOT going through; spreads are so tight that the profits on one deal break can more than pay for other losses. Reverse CB arb is where you short the CB and BUY the stock; this can work in a declining vol and rich CB environment and depends on the borrowability and exact terms of the specific CB. Algorithmic trading is so popular nowawdays that arbing some of the better known algorithms can work. Trend following is well known these days that arbing the trend followers can be lucrative; trends are readily identifiable therefore it is quite easy to know what positions certain funds have on. Once a particular trend ends their behavior in exiting the trade can become predictable and exploitable.
Much arbitrage nowadays is really spread trading. While the dictionaries need to be updated and the academics educated, arbitrage could be considered to underlie everything that a true hedge fund does. Namely the identification, monetization and risk management of inefficiencies, anomalies and mispricings. That's as good hedge fund definition as any.
The inspiration for this post came from my wandering over to pick up a crisp stack of bills of "arbitrage" profits yesterday that had been lying in the corner courtesy of ISE stock and call options. Having priced and traded options for longer than I care to remember and with the global consolidation of exchanges and the options trading boom it seemed "obvious" that ISE would eventually get bought out at a high premium. But not everyone saw what was an easy and relatively low risk trade. It was an "arb" because the acquisition value of ISE was clearly higher than the value accorded it by the public markets. If only it was always as easy as that. Most arbs are much more difficult.
by Veryan Allen.
No comments:
Post a Comment