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This New Fund Might Convert You

A pure-play on a hybrid strategy.

Mallory Horejs, 06/14/2012

Although hedge funds have run convertible arbitrage strategies for decades, mutual funds have yet to rush into the space. While the strategy has delivered uncorrelated, positive returns over the long-run, many investors remain hesitant because of the relative illiquidity of convertible bonds and the large losses convertible arbitragers suffered during the financial crisis. Calamos Market Neutral Income CVSIX, launched in 1990, was the first mutual fund to provide convertible arbitrage exposure (the fund follows a two-part strategy: convertible arbitrage and a partially hedged covered-call strategy). More recently, several multialternative funds, such as Absolute Strategies ASFIX and Hatteras Alpha Hedged Strategies ALPHX, which dedicate a portfolio sleeve to convertible arbitrage, have also launched.

Last month, though, Palmer Square Capital Management launched Palmer Square SSI Alternative Income PSCIX, the first “40 Act” mutual fund dedicated solely to this truly alternative strategy. With Calamos Market Neutral Income now closed to new investors and multialternative options offering only limited exposure to this strategy, investors interested in incorporating convertible arbitrage may want to give this young fund a closer look.

Convertible Arbitrage 101
A convertible bond is a traditional bond plus an embedded equity call option, which allows the holder of the bond to convert into equities at a predetermined conversion price. The bondholder earns the coupon rate plus any upside potential of the stock if it rises above the conversion break-even price. Companies issue convertible bonds because they pay lower coupon rates for convertibles than for plain-vanilla bonds, albeit at the expense of diluting shareholders.

The convertible-bond market is relatively illiquid, as total issuance is small and not all traditional bond investors can buy convertible securities (because of liquidity and credit-rating restrictions, and so on). Therefore, there may be pricing inefficiencies for market participants, such as hedge funds or alternative mutual funds, willing to take on this illiquidity risk. The mispricing may be due to inadequate credit research or changes in volatility, which influence the price of the embedded option.

A convertible-arbitrage strategy involves buying a convertible bond and shorting the stock of the same issuer. The goal is to profit from the mispricing of the convertible bond, either in the bond or the embedded option, while hedging out any stock market risk. Typically, convertible arbitrage requires a dynamic hedge. (When the convertible bond changes in value, the hedge must be revalued and adjusted.)

Convertible Arbitrage From a Historical Perspective While Palmer Square SSI Alternative Income is new to the market, there's plenty of historical evidence demonstrating how convertible arbitrage has held up over a longer period. Market-neutral strategies like this that bet on spread convergences between similar assets come in three basic flavors: convertible arbitrage, merger arbitrage, and equity market-neutral. Over the past 10 years, these relative value strategies have generated modest, steady returns with relatively low correlation to the equity market. The Morningstar MSCI Convertible Arbitrage Hedge Fund Index, for example, has returned 4.31% annualized and exhibited a 0.50 correlation with the S&P 500 Index over the past decade.

Furthermore, because of their low equity market exposure, most market-neutral strategies made it through the financial crisis relatively unscathed and provided valuable downside protection. This wasn't the case for convertible arbitrage--2008 presented significant problems for less-liquid asset classes such as convertible bonds, and investors seeking liquidity fled these funds en masse. Redemption requests combined with tumbling market prices led to extremely poor performance and caused many convertible-arbitrage hedge funds to shutter.

The biggest problem with these hedge funds, though, was excess leverage. Like other highly leveraged hedge fund strategies, the Morningstar MSCI Convertible Arbitrage Hedge Fund Index, illustrated by the red line in the chart below, followed the S&P 500 downward a whopping 29.93% in 2008. For comparison, Calamos Market Neutral Income sank less than half that, negative 13.3%. While that was the largest annual loss in the market-neutral mutual fund category by far, it's clear that the mutual fund's restrictions on leverage led to better downside protection when investors needed it the most. And avoiding this large drawdown has helped Calamos Market Neutral Income to outperform the Morningstar MSCI Convertible Arbitrage Hedge Fund Index on a risk-adjusted basis over the past 10 years.

Mallory Horejs is an alternative investments analyst with Morningstar.
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