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By Christine Benz | 03-08-2010 03:16 PM

Method Behind Merger-Arbitrage and Managed Futures

AQR's Cliff Asness describes the strategies behind the firm's merger-arbitrage and managed futures funds.

Christine Benz: You've got two funds, a Managed Futures Fund and a Diversified Arbitrage Fund. You were just talking about the strategy needs to be simple and explainable. Can you quickly explain how those two funds go about their business?

Cliff Asness: Sure. Diversified Arbitrage is a set of strategies. I'll talk about one mainly, being merger arbitrage. The two most prevalent ones are one called merger and one called convertible arbitrage. They are far from the only things we do, but we have limited time so I'll focus on one of the two biggies. Merger arbitrage says when a merger is announced, what happens? The target goes way up, but it doesn't go up all the way. If someone offered to buy a target, it was at $60 and offered to buy it at $80, it goes up to $76.

Why is it? Because no one knows for certain that deal's going to go through. To someone who only owns that stock, that looks very scary. They could lose all or more of their gain to get a little more.

To a merger arbitrageur--I have trouble saying "arbitrageur" even without a camera on. I want to point out to everyone I said it right twice in a row there--you'd be terrified if you only did that deal, if you only did that merger. So what you do is many of them in a very diversified way.

It turns out that all the small closings way more than pay for the few disasters. It's a very accurate analogy to selling life insurance here. I don't mean to be morbid, but as a life insurer you don't expect nobody to die. It'd be a nice world, but that's not what you expect.

What we've found is if you look literally over 45 years now, we go back to the mid '60s, in looking at this, if you do a fairly diversified, I won't call it a total index fund, but a fairly diversified set of mergers, way more diversified than the average merger arbitrage manager does, it's not magic.

It's not about picking the three deals that are going to close. If you do a very diversified set of them, accept some of your losses, the gains far outweigh the losses and can be delivered at a far more reasonable fee than someone who's claiming it's magic and they're a genius.

I'm stating for the record here, we're not geniuses. We're just doing something we think is reasonably...

Benz: You have a broad basket.

Asness: Exactly. Something reasonably smart. That can be done with a very low correlation of market. It's a source of return that's positive. Again, it's not just mergers in the fund diversified, and the name means we're doing a whole set of arbitrage strategies.

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