Hedge Funds - Convertible Arbitrage

Convertible Arbitrage - This hedge fund strategy primarily involves taking long positions in convertible bonds hedged with a short position, typically in the underlying stock. Convertible bonds and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk-free rates and the issuer-specific corporate yield spread. However, in many cases, convertible bonds and warrants are not accurately priced due to illiquidity in the convertible and warrant markets compared to the markets in the underlying common equity of the stocks, uncertainty concerning the call and redemption features of convertible securities and lesser focus on these derivatives as opposed to the equities into which they are convertible or exercisable. These mispricings may lead to significant profit opportunities for hedge funds, as positions are acquired in anticipation of the market price eventually reflecting true value. Historically, this strategy has been one of the best hedge fund approaches in terms of Sharpe Ratio.

Who Needs Hedge Funds

With all the negative publicity concerning Hedge Funds lately, I wonder why anyone would even want a part of these investments. A decent Investment Advisor will often offer investment products that are totally transparent (unlike Hedge Funds), no incentive fees, and great return potential.

Hedge funds have a significant failure rate. Some strategies, such as had an attrition rate as high as 15% per year between 1994 and 2003, according to a study. It cannot be denied that failure is an understandable part of the process speculative financial investments, but when large, popular funds close, there is a lesson for investors somewhere in the debacle. When you see Hedge Fund returns in the Wall Street Journal, or other financial publications, they omit the funds that have gone out of business. This, of course, inflates the actual investment return of these funds.