If there is justice in the world, then we can rest easier because hedge fund managers are having just as hard a time with these financial markets as the rest of us. The Hedge Fund Research Inc. index of hedge fund returns declined 4.7% for September, and for the first nine months of 2008 the index is down 17%. While this might not be as much of a loss as the broader stock market (the Standard & Poor's U.S. Broad Market Index was down 9.29% in September and down 19.47% for the first nine months of the year), it does reflect that all is not golden with hedge fund managers.
So, why are hedge fund managers having such a difficult time don't they like market volatility? As a matter of fact, many hedge fund strategies don't perform well in very volatile financial markets.
Many hedge fund models are based on arbitrage strategies. The technical definition of arbitrage is riskless profits. For example, if you can buy security A at $10 in immediate cash and simultaneously sell it for $11 in immediate cash, you have an arbitrage profit of $1.
However, there is risk in hedge fund arbitrage strategies, as the poor performance of the HFRI index indicates. In the nomenclature of the hedge fund world, arbitrage strategies are often called convergence trades. These strategies bet that the prices of different but similar securities will converge over time.
These strategies are also called short-volatility strategies. They profit when market volatility is low. However, when the market becomes very volatile and uncertain, we can get unusual pricing dynamics, unusually wide spreads between two similar kinds of securities. In volatile markets, prices of similar securities move away from each other. When this happens, convergence strategies will lose money.
Furthermore, since the profit from a convergence trade is usually small, hedge fund managers often employ a significant amount of leverage to maximize the amount of the financial premium they can collect. In less volatile markets, this strategy works well. In volatile markets, however, the use of leverage only exacerbates the losses of the hedge fund manager.
Ideally, in a convergence or short-volatility trade a hedge fund manager looks for two securities that are similar in economic fundamentals but differ in price. For example, the current 30-year Treasury bond is yielding around 4%. By comparison, a 30-year AAA municipal bond with an insurance guarantee currently yields around 5.3%. While municipal bonds do not enjoy the protection of the full faith and credit of the U.S. government, they have the authority to tax and have historically had very low default rates. Normally, AAA municipal bonds trade at yields less than U.S. Treasury bonds because municipal bonds offer tax-exempt income compared with the taxable interest offered by Treasuries. However, in our current market crisis, there has been an excessive flight to safety and the prices of municipal bonds have diverged from their long-term historical relationship to U.S. Treasury bonds.
When price discrepancies like this occur, hedge fund managers execute a convergence trade. Based on that long-term relationship, we would expect the yields on municipal bonds to decline and their prices to rise and the yields on U.S. Treasury bonds to rise and their prices to fall.
A hedge fund manager can execute a convergence trade to buy municipal bonds and sell U.S. Treasury bonds with the expectation that the pricing relationship between these two types of bonds will converge back to normal over time. If this convergence takes place, the hedge fund manager will earn a profit.
Convergence trades come in all shapes and sizes. A hedge fund manager might expect off-the-run Treasury bond prices to converge toward on-the-run Treasury bond prices over time, or the stock prices of two similarly capitalized companies in the same industry with the same economic prospects to converge toward one another over time. The basic execution of a convergence trade follows the same rule: Sell the security that appears to be overvalued and buy the same or similar security that appears to be undervalued with the expectation that, over time, the two security prices will intersect in value.
If all goes according to plan, and a convergence trade works, the hedge fund manager typically earns a small profit. Price discrepancies between securities with similar fundamentals are fleeting, and the discrepancy tends to be small and not as large as our municipal bond/Treasury bond example. However, if the convergence trade does not work and the prices of the two securities diverge instead of coming together, the hedge fund manager is on the hook for the loss.
This is very similar to how an insurance contract works. Consider homeowner's insurance. Under normal conditions, your home does not incur any fire, wind, water or other damage. The insurance company then happily collects your annual premium. However, if there is damage, then you can put back your losses to the insurance company and the insurance company is on the hook for the economic loss. I use the term put back because this is exactly what an insurance contract is: a put option. An insurance contract entitles you to put your losses back to the insurance company just like the exercise of a put option.
Now, back to our hedge fund manager. If the convergence trade works as expected, the hedge fund manager will collect a small profit, just like collecting an insurance premium. In fact, the hedge fund manager is insuring that the prices of two similar securities will converge over time. In order to be compensated for this insurance, the hedge fund manager collects a return based on the difference in value between the two securities when their prices intersect. However, if the convergence trade does not work, the hedge fund manager must bear the losses just like an insurance contract.
Our conclusion: convergence trades expose hedge fund managers to the risk of market turmoil and volatility, much like the markets we are experiencing right now. And, as sellers of financial market insurance, hedge funds bear the cost of turbulent markets. While comfort has been scarce in markets recently, it is gratifying to know that hedge fund managers are out there protecting our interests in their own way!
Mark Anson is president and executive director of investment services at Nuveen Investments Inc., Chicago. The views expressed in this commentary are his own and not necessarily those of the firm.