The rise in demand for alternative investments has been a dominant theme in the financial advisory industry as of late. While many have focused on advisor demand for private markets, it should be noted that hedge funds can play an important role in diversifying client portfolios and potentially improving risk-adjusted returns. Understanding the nuances of various hedge fund strategies is crucial for financial advisors to fulfill their fiduciary duty and effectively recommend investments that are the best fit for their clients. To do so, advisors should be able to explain and recommend strategies that are suited to the current market environment and have the best chance of protecting and enhancing their clients’ wealth. Interestingly, there is one hedge fund strategy that is resurging in popularity with institutional investors, and as such, is likely poised to gain popularity with financial advisors in short order: convertible arbitrage.
To simplify this complex strategy, convertible arbitrage involves taking a long position in a convertible bond, which can be converted into stock, and a corresponding short position in the underlying stock, to exploit price discrepancies. If the stock’s share price falls, investors can profit from their short position, and if it rises to a certain level, then investors can convert the bond into stock. In many cases, this can be a win-win situation for investors to exploit.
This strategy was one of the cornerstones of the hedge fund industry in the 1980s and 1990s, and widely used for its high return potential and risk mitigation. Until 2001, about one third of all investments in hedge funds went into a convertible arbitrage strategy, according to research from NYU Stern.1 However, the global financial crisis sent the strategy’s popularity tumbling. When Wall Street firms failed, managers experienced a near 40% drawdown, assets under management in the strategy declined and numerous arbitrage funds closed, as found by the Man Institute.2 Investors turned to other strategies to hedge their portfolios.
The macro environment today has shifted, making convertible bond issuance an attractive proposition for companies again, which in turn has increased the opportunity set for convertible bond arbitrageurs. The increase in issuance is driven by the fact that interest rates are currently lower for convertible bonds than those provided on conventional debt, making borrowing cheaper for corporations issuing these bonds. New U.S. convertible offerings totaled over $40 billion as of June 14, an 85% increase year-over-year, and this volume is projected to reach $94 billion annually, according to Barclays.3 Beyond this, equities are near historic highs, companies are keen to refinance pandemic-era debt, and there is a looming wall of bonds totaling $115 billion set to mature between now and 2026, as reported by Bloomberg.4
While there are dedicated convertible arbitrage managers, it is important to note that many of the largest multi-manager hedge funds, or ‘pod shops’ as they are known, have portfolio teams that execute convertible arbitrage strategies, and, in some cases, have tighter risk controls and more prudent use of leverage than they did before the global financial crisis.
Therefore, for those advisors whose clients are invested in these large multi-manager funds, it can be useful to understand how the strategy works, so that they can have more informed discussions with clients about what is driving the returns of the hedge fund portfolio. Convertible arbitrage strategies can provide diversification, and they have a low correlation to traditional markets, which can reduce portfolio risk. Conversely, there are several idiosyncratic risks with which managers must contend. These include volatility and liquidity concerns related to buying or selling convertible bonds during market stress, as well as more specific company issues like deteriorating conditions in stock borrowing and unfavorable strategic acquisitions.
When considering convertible arbitrage for a client’s portfolio, advisors should ascertain the client’s risk tolerance and investment horizon. Many hedge fund strategies are most suitable for those with higher risk tolerance and longer investment horizons, as these strategies involve greater complexity and risk, and can be subject to short-term volatility in interest rates, credit spreads and stock price movements. Investors with longer time horizons are better equipped to handle this volatility and the monthly or quarterly redemptions offered by these funds, which allows hedge funds to hold positions until more favorable conditions arise to exit them.
For clients wanting access to convertible arbitrage, advisors should partner with alternative investment platforms that conduct thorough due diligence and can identify managers and strategies with proven track records that will complement a client’s traditional investments portfolio.
A conversation regarding convertible arbitrage with your clients may not seem necessary. However, it is relevant for clients who already have or want alternative investment exposure in their portfolios. In short, it is always advisable for clients to be aware of investment strategies that are gaining in popularity with institutional investors, as their goals of portfolio diversification, hedging and consistent positive risk-adjusted returns are often the same as high-net-worth individuals.
1 Yurek, Chris. NYU Stern School of Business, May. 2005. https://www.stern.nyu.edu/sites/default/files/assets/documents/con_043324.pdf
2 Song, Gil and Heavy, Eamon. Man Institute, Sept. 2019. https://www.man.com/maninstitute/convertible-arbitrages-quiet-evolution
3 Shen, Yiqin. Bloomberg, Jun. 2024. https://www.bloomberg.com/news/articles/2024-06-26/us-convertible-bond-boom-to-near-covid-era-peak-barclays-says
4 Shen, Yiqin. Bloomberg, Jun. 2024. https://www.bloomberg.com/news/articles/2024-06-18/aqr-hails-comeback-of-convertible-arbitrage-in-era-of-high-rates
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