Convertible Bond Hedge Funds Get Off to Worst Start Ever

[HenryTo]

Okay, I think everyone is getting tired of our discussions on oil, real estate, etc. Let's talk about hedge funds. Everyone seems to be in agreement that at some point in the next couple of years, there will be a general shakeout of the hedge fund industry. Too much money chasing too few talent, they have said. Are the most recent recent losing ways of convertible bond hedge funds indicative of what may happen to the general hedge fund industry - say, to long-short equity hedge funds? Food for thought:
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Convertible Bond Hedge Funds Get Off to Their Worst Start Ever
June 21 (Bloomberg) -- Hedge funds that invest in convertible bonds posted their worst performance ever during the first five months of this year.

Convertible-bond arbitrage funds, which have about $45 billion of assets, fell 6.73 percent on average in the five-month period, the biggest losses since Chicago-based Hedge Fund Research Inc. started keeping records in 1990.

GLG Partners LP's Market Neutral Fund was down 17.2 percent as of May 31, according to data compiled by Bloomberg. Marin Capital LP, a $1.4 billion fund in San Raphael, California, told investors last week that it would be liquidated because of a ``lack of suitable investment opportunities.''

The decline has affected investor confidence in a $1 trillion industry that's supposed to do well whether financial markets are rising or falling. A net $1.8 billion was redeemed from convertible bond funds in the first quarter, according to estimates from Tremont Capital Management Inc. of Rye, New York.

For investors such as Mark Yusko of Chapel Hill, North Carolina-based Morgan Creek Capital Management LLC, the slump represents a buying opportunity. ``We'll have one more quarter of pain and then the next 15 months will be good,'' he said.

Yusko said his clients should have 3 percent to 5 percent of their $1.2 billion in convertible securities by the end of the year. Convertible bonds are approaching record-low valuations, he said in an interview.

``We made a decision in mid-April to increase our exposure,'' said Richard Yakomin, a partner at Gemini Investment Strategies LLC in Parsippany, New Jersey, a $97 million fund that specializes in convertible bonds. ``Attracting capital to the strategy this year has been nearly impossible, but we're sensing more interest.''

Spread, Volatility

A convertible bond gives the holder the option to exchange the bond for the issuing company's stock at a preset price. The price of a convertible bond depends on two factors: its yield in relation to U.S. Treasuries, called the spread, and how much stock prices overall are expected to move, a measure known as volatility.

Convertible bonds perform best when spreads are wide compared with other bonds and volatility is high. High volatility makes the equity option of the bond more valuable.

Hedge funds started selling convertible bonds 12 months ago as the spread on the bonds narrowed and volatility fell, driving down prices. They also sold to meet expected withdrawals by investors frustrated with lower returns. The sales depressed prices even more.

Throughout much of the 1990s, convertible-bond arbitrage funds posted average annual returns of more than 12 percent, according to Hedge Fund Research. Returns were about 10 percent in 2003 and declined to 1.2 percent last year.

Not So Neutral

Traders say convertible bonds are cheap because their so- called implied volatility -- the amount that traders expect the prices of the underlying stocks to fluctuate -- is lower than the actual fluctuations of those stocks in the past 90 days, according to research from Lehman Brothers Holdings Inc. Usually the expected volatility is higher than the actual volatility because investors can't be sure about the future.

The last time implied volatility fell below actual volatility was in January 2003 and convertible-bond hedge funds climbed about 11 percent in the next 12 months, Hedge Fund Research reported.

Hard Hit

Yields on non-investment grade convertible bonds climbed relative to Treasuries since the end of last year, widening by 1.53 percentage points to 6.31 percentage points. High-yield bonds have widened just 96 basis points to 3.84 percent above Treasuries, according to Lehman Brothers.

``You're getting a lot more spread for volatility than you did a year ago,'' said Michael Revy, head of research at Los Angeles-based Froley, Revy Investment Co., a convertible-bond manager with $4.1 billion in assets.

Gemini's Yakomin said he's been investing in Lamar Advertising Co., which has risen in price from 91.187 at the start of May to 104.25 today and Skyworks Communications Inc., which climbed from 95.467 at the beginning of last month to 102.543.

An improvement in convertible arbitrage fund returns would help boost overall industry returns, which aren't much higher than the Standard & Poor's 500 Index, which fell 0.96 percent through May, and the MSCI EAFE Index, which dropped 2.18 percent. Bonds have outpaced hedge funds, rising 1.95 percent according to the Lehman Brothers Aggregate Index.

Still, some investors and mangers are concerned that some convertible hedge funds may face more redemptions, which could send prices lower again. There also is the chance that stock volatility may stay low.

``Everyone is circling in converts, but everyone is a little bit wary,'' said Patricia Young, who manages the $400 million NewMarket Capital Partners Select Fund LP in Philadelphia, which invests in hedge funds.

[nodoodahs]

Henry,

I think the trouble with hedge funds may be methodological one. Don't many hedge funds express their investment quality or strategy in terms of a Sharpe ratio?

Have you seen a graph of a high Sharpe ratio with a market-neutral or slighty higher average, compared to a graph of the normal distribution of market returns?
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.