Arbitrage hedge funds
Convergence trading hedge funds, or arbitrage hedge funds try to discover situations where two related securities are mispriced relative to one another. They buy the relatively underpriced security and sell the relatively overpriced one. Profit is made when the price relationship gets back into “normal”. Arbitrage funds typically use sophisticated computer models, as computers are faster in discovering mispricing than human beings. The mispricing is often very small and high leverage is used.
Risks of convergence trading strategies
High leverage is the main risk with arbitrage strategies – when the mispricing doesn’t get back to “normal” and things go wrong, they sometimes go very wrong. Until this happens it is very difficult to detect the risks, as historical performance often looks outstanding from the risk-return perspective.
Common trading strategies of arbitrage funds
- Fixed Income Arbitrage – betting on price differences between related bonds and interest rates.
- Volatility Arbitrage – exploiting price inefficiencies in valuations of options.
- Convertible Arbitrage – offsetting a position in a convertible bond by a position in its underlying stock (most typically buying a convertible bond and selling short its underlying stock).
- Equity Market Neutral – taking long and short positions in individual stocks. The key difference vs. strategies in the equity market directional group is the strictly neutral overall equity market exposure (long and short positions exactly offset each other).
(In)famous example of convergence trading funds
An example of arbitrage funds was John Meriwether’s Long-Term Capital Management. The giant fund with Nobel Prize laureates Myron Scholes and Robert C. Merton in the team was first adored by the whole Wall Street and then in 1998 almost caused the whole Wall Street to collapse. It was bailed out by major banks under supervision of the Fed. LTCM was mostly trading fixed income spreads.
A great book was written about the LTCM story. Its value is mainly in the behind the scene insight – it illustrates well how the different personalities and relationships within the fund management team contributed to the eventual excessive risk taking and collapse. See Roger Lowenstein: When Genius Failed: The Rise and Fall of Long-Term Capital Management.