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Method Behind Merger-Arbitrage and Managed Futures

Christine Benz

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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If you flip to what we do in Managed Futures, the goals are very similar. It's to deliver return over the long haul that's positive--negative return is bad; we've established that--but to do that with a very low correlation to traditional markets.

Managed Futures works in a very different principle. Arbitrage says if things are mispriced, they tend to fix themselves. Managed Futures say, and gobs of academic and practitioner research back this up, that momentum trends exist in this world. When something is moving one way, it tends to keep moving that same way.

We didn't call it this, but you could have called it the Diversified Managed Futures Fund, too. We'd be copying our other name, and that would get boring.

But we look at trends in equity markets around the world, bond markets around the world, currencies and commodities. Again, there's always going to be some complication.

We have our own ways of doing it. We look at long term trends, short term trends. We do a bit of work on trying to say when a trend's overextended, but it's largely a bet that trends in existence will keep going. Because trends do tend to keep going on average, that has paid off over the very long term.

But interestingly, a little different from Diversified Arbitrage, which strives for a low correlation, Managed Futures is not just low correlation but tends to historically have done very well in extreme markets.

Benz: So big, buoyant 2008, 2009...

Asness: Crash of '87, 2008. 2008 was a great example. 2008 might have felt like a blow, a bolt from the blue, but there were anywhere between six to 12 months of trends building up before they really went ballistic on us. So it was a wonderful year for trend-following strategies. That's not a panacea. It's not going to fix every bear market in the world. But more often than not, we think these are strategies that will make money over the long term that actually have low correlation normally and do particularly well when crazy things--crazy good or crazy bad--but you particularly care about crazy bad.

So what we're trying to do is charge reasonable fees, do simple strategies, and bring some of these alternatives to regular investors.