How often do you encounter a perfectly good product that is advertised as something it’s not? RedBull doesn’t actually give you wings and Axe Body Spray doesn’t make women break into your house. What these advertisement methods share is appeal to their target audience.
The academic definition of ‘arbitrage’ is a method of making money on price differentials where a risk-free profit can be earned. True arbitrage opportunities are the closest thing in finance to picking up free money on the ground, and the allure of uncovering these rare gems makes the term a perfect candidate for marketing abuse.
Here are 6 hedge fund strategies that are often called arbitrage, but ultimately may take on substantial risk:
- Merger Arbitrage
When company A trades at $9.75 a share and company B intends to acquire it at $10 a share, it seems like a classic arbitrage scenario. Buy ‘A’, sell ‘B’, and make a nice spread in the middle. The problem is that you’re not making a riskless return, as you’re generally taking a bet on a binary outcome that is often highly correlated to equity markets.
When a deal falls apart, company A’s shares are likely to drop substantially, which sets an investor up for a nasty drop. In 2008, merger deals dropped at an alarming rate, and in general, mergers tend to fall apart when the market drops substantially. Beyond the natural correlation of the strategy to the market, merger arb deals often apply leverage in order to magnify returns, which heightens the market sensitivity.
- Statistical Arbitrage
The term statistical arbitrage covers a lot of quantitative strategies, and it’s become somewhat of a catch-all for many market-neutral quant funds.
The classic stat-arb trade is a mean-reverting pair trade where one stock has deviated from its historical correlation to the other. The trade is to sell the theoretically expensive stock and buy the cheap one, and profit when they revert to historical trends.
The problem is that this might not actually be a pricing ‘inefficiency’ that needs to be exploited. It could simply be that past trends are no longer meaningful, and that the theoretical relationship between the two stocks was spurious.
The risk profile of this strategy can be quite high: there are stock specific risks, possible model weaknesses, the risk of leverage to magnify the gain on pricing ‘inefficiencies’ and the fact that the future is generally unpredictable.
Additionally, there can be herding behavior among statisticians just as with any other strategy; in 2007 the “Great Quant Meltdown” occurred when quant shops all crowded into the same statistical-based trades. A stat-arb book may be diversified over hundreds of positions, but if the FACTORS being bet on are concentrated the fund can experience major losses.
The bottom line is that a stat-arb book could consist of just about anything, and due-diligence is required to understand the true risk exposure of the underlying strategies.
- Option-Volatility Arbitrage
Like statistical arbitrage, volatility arbitrage relies on probabilities rather than certainties. Key questions: “What portfolio risks are you assuming?” “Are you long, short, or neutral volatility?” “What is your exposure to the movements of the market or the underlying securities?” “Under what conditions do you lose money?”
- Convertible Arbitrage
In convertible arbitrage, investors make profits by trading on price differentials between a company’s convertible bond and their equities. While these trades used to offer substantial return with minimal risk, several problems exist in today’s market:
- The strategy has become very popular and returns have become muted. The same risks of ‘crowded trades’ exist, whereby even if the trade is on sound fundamental footing, an unwinding of a major player in the market could push prices out further and produce short-term losses.
- The multitude of convert strategies take on real risks including exposure to volatility, credit spreads, and movement of the underlying stock.
- Lastly, the muted returns have led many firms specializing in this space to apply leverage, which turns up the volume on all of the aforementioned risks.
In sum, convert arb is quite different than buying oranges in market A and selling them in market B.
- Capital Structure Arbitrage
Simply put, an investor using a capital structure arbitrage strategy will go long one security in a firm’s capital structure and short another, hoping to profit off of an inherent risk/return differential between the two. The problem is that credit, equities, and options all tend to move for very different reasons (e.g.: sometimes the equity goes to zero while the credit actually does stay in-tact). Firms that short credit instruments or buy options are also fighting with negative carry positions, which can induce ‘death by a million cuts’.
A great example is Saba Capital, a once $5.5b capital structure arb fund that has been down 3 years in a row, largely due to a negative carry stance. In 2014 it was down 11 out of 12 months and bled out -11% returns on the year, according to Bloomberg.
- Closed End Fund Arbitrage
Closed End Funds (CEFs) issue a fixed number of shares which then trade freely on the market. They also post Net Asset Value’s daily and make their holdings available. In theory, a fund’s share value should be equal to its net asset value. In practice, many funds trade at significant premiums or discounts to their underlying NAVs. Hedge funds who recognize this inefficiency may go long or short a basket of the mutual fund’s holdings in an effort to capture the ‘spread’ between the two values.
The problem is that while these inefficiencies clearly exist, they often take years to correct (or sometimes never do). Part of the reason is liquidity, which can make transaction costs very high. Additionally, the cost to borrow the securities to short may be very high, which erodes or eliminates any potential alpha.
Beyond friction, sometimes the ‘spreads’ between CEFs and their underlying holdings can widen even more irrationally for prolonged periods of time. A manager we were speaking with recently said that in 2008 the difference between mutual fund NAVs and their shares could widen as much as 35%+.
This reality underlines the age-old adage: “Something is only worth what someone is willing to pay for it.” Waiting for Keanu Reeves to change his facial expression may be more rewarding than investing in some Closed End Fund shares.