NEW YORK - Ask many convertible arbitrage hedge fund managers - and many of those managers' investors - and they'll tell you the strategy provides steady returns in volatile markets.
But ask some fund-of-funds managers and they'll say they worry too many assets are concentrated among too few individual hedge fund managers. That, say fund-of-funds managers, could lead to liquidity problems. If a couple of large hedge funds decide to sell, it could trigger a wave of selling with nobody to buy.
Convertible arbitrage hedge fund managers say they're aware that the balance of assets has shifted in recent years so that now between 60% and 70% - or about $15.5 billion - of all convertible paper is held by arbitrageurs. But that's not necessarily cause for concern, they add.
The critics "are correct that the convertible arbitrage market is dominated today by (hedge fund) managers," said Robert Butman, president and chief executive officer of TQA Investors LLC, a Stamford, Conn.-based hedge fund. "However, the mere fact that hedge funds are 60% or 70% of the market today hasn't been a problem at all, and shouldn't be a problem unless we get into scenarios where everybody wants to sell and the only buyers are other hedge funds who are looking to get out, too. That could cause a problem, but that can cause a problem in any market, right?"
It can. And that's exactly what some fund-of-funds managers are worried about.
Returns plus interest
In the sometimes complicated strategy of convertible arbitrage, hedge fund managers buy and hold convertible bonds, which allow the holder to convert the bond into corporate stock at a fixed price. At the same time, managers short the corresponding underlying equities, creating a market-neutral position. That way, they get the returns from interest on the convertible bond plus additional interest on the proceeds from shorting the stock.
The value of an embedded option in the convertible bond fluctuates with the underlying stock price. The biggest risks lie in bond quality and equity market volatility.
The concern on the part of hedge fund-of-funds managers lies in the fact that hedge fund managers are holding the corporate bonds as a hedge instrument, not a long-term investment as a mutual fund would.
One problem with this is when there are many more hedge fund buyers in the market than other kinds of buyers, there is a mismatch between natural buyers and sellers. This can create what Mr. Butman calls "pockets of illiquidity," where the relatively few mutual funds, insurance company and pension fund investors are buying higher quality convertible bonds and the more numerous arbitrageurs are buying the lesser quality convertible bonds. When that happens, these pockets can form in the middle tier of convertibles.
But even though such pockets have opened up in recent years, convertible arbitrage performance has not suffered. In fact, trailing 12-, 18- and 24-month returns for Garden City, N.Y.-based Ivy Asset Management Inc.'s convertible arbitrage funds are 15%, 28% and 37%, respectively.
Still, the question of a possible liquidity problem in convertible arbitrage is a "timely, topical question," said Adam Geiger, a former convertible arbitrage manager and now Ivy's director of investments for its hedge fund of funds.
`Sources of liquidity'
"Hedge funds have become the sources of liquidity," Mr. Geiger said. "If in a negative case everyone wants to sell, who's going to buy? That's an interesting and potentially dangerous situation. You always want to be with someone providing liquidity rather than the one demanding the liquidity."
And right now, Mr. Geiger sees plenty of liquidity providers in the convertible arbitrage world. He also sees a couple of other things that mitigate the risk of high concentrations of assets among arbitrageurs. First, leverage in convertible arbitrage is low, as low as it has been in years. Ivy's dedicated market-neutral fund right now has the lowest aggregate leverage it has had in the four years Ivy has tracked leverage. Second, the strategy performed well in a difficult September market following the attacks on the World Trade Center and the Pentagon.
"The asset class performed very, very well in a stressful environment," Mr. Geiger said. "There's a lot of cheap credit exposure out there and a lot of opportunities. If we're relying on the arbs to provide liquidity to each other, at some point the well might run dry and that's where the risk lies. But thinking about that doesn't keep me up at night."
Likewise, Shoaib Kahn, vice president of research for LJH Global Investments LLC, Naples, Fla., said he's confident convertible arbitrage will continue to perform well despite a concentration of assets among hedge fund managers.
Mr. Kahn said he's confident in the strategy because he knows there are a lot of convertible arbitrage managers providing liquidity - around 100 in the United States alone. He also knows demand for convertible arbitrage products is growing among all kinds of investors, including pension funds. Demand, he said, will drive buyers as well as sellers. And finally, Mr. Kahn considers a scenario in which all hedge fund managers are trying to sell a worst-case scenario, and an unlikely one.
"If they all decided to get out, it would create a crunch. But there are no catalysts we see to make that happen," Mr. Kahn said. "There is a caution out there. We are monitoring it, but we're still bullish on the strategy."