Arbitrage disruption hits hedge funds

Arbitrage strategies at the heart of the hedge fund industry were decimated last week, as a combination of fire sales of assets from investment banks and worldwide restrictions on short selling hit their profits.

Convertible bond arbitrageurs had the worst performance of any hedge funds, according to investors, as large portfolios of bonds were dumped into the market – probably, said several managers, as Lehman Brothers’ proprietary trading desks closed.

The heavy losses for convertible arbitrage, coupled with the removal of the funds’ ability to lower the risk of holding bonds by short selling the linked equity, could make it much more expensive for companies trying to raise capital through convertibles, managers said. Convertible bond arbitrage involves hedging out the equity or credit risk, or both, often trying to profit by trading the value of the embedded option to convert the bond into shares.

So far this year, banks and other financial companies in the US have raised more than $35bn, one fund calculated, as the convertible bond market – which is dominated by hedge funds – remained one of the few still open at a reasonable price.

The average convertible fund lost more than 4 per cent, according to Hedge Fund Research’s daily indices, as the specialists had one of their worst weeks.

“Although they are not getting fall-off-your-chair hammered, they are among the worst out there,” said one investor in the sector, who said several large funds were down 7-8 per cent in the week.

Other arbitrage strategies have also had a terrible time as the combination of deleveraging and forced sales made common trades in the fixed income and equity markets go awry.

The same effects hit some event-driven funds, as common trades – such as the bet on Volkswagen’s share price versus its preference shares – were hit by forced sales and the fallout from the collapse of Lehman.

Computer-driven hedge funds, which use statistical arbitrage to look for small mispricings in shares, have also had a tough time, as the new short-selling rules forced them to scrap all or part of their models.

However, the biggest hedge fund sector, which follows equity long-short strategies betting both ways on share prices, ended the week down only 1-2 per cent, several investors said. The HFRX global index, including all hedge strategies, was down 1.4 per cent.

“Obviously nobody’s making money apart from the CTAs [managed futures traders], but in the long-short market nobody’s dead,” said another hedge fund investor.

Funds have just begun reporting weekly numbers so it remains unclear how badly the worst were hit and whether any switched their positions at the wrong time.

Some managed futures traders, who typically use computer models to follow short term or medium term trends in futures markets, did very well, several investors said, as did funds trading volatility.