Hedge fund arbitrage? Proper hedge funds identify securities that are trading above or below their "correct" price. Some would argue that arbitrage only applies when the same security is bought and sold simultaneously with zero residual risk. Economists even claim there can be no such thing as arbitrage since any such trade would quickly be copied and therefore eliminated! They are so WRONG.
An academic metaphor is that if a $100 bill were dropped in the street then it would immediately be picked up therefore no arbitrage can exist or persist. But what if YOU happen to be the person that finds the note? Someone will. What if you specialize in walking the streets 24/7 looking for drops? What if you spent some of the "high" 2 and 20 fees on lots of employees and technology to monitor more streets in many other cities and countries?
What if you had the lowest latency execution and modeled trends and behavior so you could identify the streets with the highest probability of rewards. What if your costs are low enough that you can make a profit from picking up $10, $5 or $1 bills - even quarters? What if your computers are so quick they can catch the cash BEFORE it hits the ground? What if you monitored areas no-one else had thought to look? If you have the patience and resources there are plenty of arbs available on Wall Street just as money gets dropped in every streets each day.
Of course this can be taken too far and if the arbitrage becomes well known it becomes hazardous. Nickels in front of steamroller strategies are dumb deals where brash traders and incompetent Nobel laureates risk their fund for 5 cents and end up getting crushed for billions. Arbitrages in the PUBLIC domain will inevitably disappear. Transparency is the enemy of arbitrage so opacity is essential. The arbs you want are $100 bills and no steamrollers in sight. The best trades are waiting until there is some easy money in a corner and just wandering over and picking it up.
There are several hedge fund arbitrage strategies of which statistical arb, merger arb, fixed-income arb, capital structure arb, volatility arb and CB arb are perhaps the most well-known. Naive investors even think these are "non-directional" which is unfortunate as there is always some directional dependence inherent in a strategy. But within these categories there is a vast difference in the skill and methodologies by which these arbs are implemented. Probably only plain vanilla merger and CB arb are arbed out but even within those there is plenty of room to find non-vanilla opportunities. You just have to be VERY good at what you do. Better than 99% of other "professionals" in the strategy.
Some arbitrage amounts to short selling the liquid and going long the illiquid. That usually works fine in a bull market but can get hazardous when bearish times emerge. Some strategies have become so well-known that doing the opposite can make sense. REVERSE merger arb is betting on an announced deal NOT going through; spreads are so tight on most deals these days that the profits on one deal breaking can more than pay for other losses. REVERSE distressed debt is where you buy credit default options on "highly rated" securities likely to become credit impaired. Performed perfectly in the recent subprime mortgage and CDO debacle.
The carry trade whereby yen or swiss francs are borrowed and sold short and the proceeds invested in something with a higher yield is considered by some to be an arb. A common interest rate "arb" is borrowing short term to invest long term. There is a fair amount of commodities "arb" around playing contango and backwardation term structure. Activist equity and distressed debt hedge funds arb the difference between undervalued assets and their estimated true worth. Too many people have the carry trade on so REVERSE carry is NOW likely the best trade. Buy Japanese yen. NOW!
Lesser known but no less lucrative is model arbitrage. This is where a fund takes advantage of mispricings usually of fairly exotic derivatives and structured products. With counterparty global investment banks all keen to be seen at the "cutting edge" of financial engineering, their different models, software and underlying statistical assumptions can lead to pricing anomalies. It can be as basic as different interpolation methodologies of interest rate, credit and volatility term structures. Even a few basis points adds up when leverage, convexity and optionality get thrown in. Some providers don't seem able to measure correlation or credit risk correctly. Sometimes however the "error" is more subtle often involving stupid stochastic model based mumbo jumbo. A true quant is someone that arbitrages the other quants!
Other equity "market neutral" strategies are "analyst arbitrage" and "IPO arbitrage". A manager uses a carrot and stick approach to ensure they are the "first call" on sell-side analyst rating changes and to get into lucrative IPO allocations. Usually the carrot is paying high commissions and the stick is threatening to take their business elsewhere. There are several "hedge funds" around whose performance is NOT due to stock picking or trading ability but entirely due to their "skill" in analyst arb and brokers seeking favor by providing "market color" on other clients' positions and imminent transactions for front running. Is that skill? I don't think so and I don't allocate to those funds.
Algorithmic trading is so popular these days that arbing some of the more popular trade execution systems can work. Trend following has become so well known that arbing trend followers is possible; trends are readily identifiable therefore it is quite easy to know what positions certain funds have on. Once a particular trend ends, their behavior in exiting the trade can become predictable and exploitable. Again this is where black box trading systems must remain opaque otherwise performance will be temporary. Very temporary.
While the dictionaries need to be updated and the academics educated, arbitrage could be considered to form the basis of everything a true hedge fund does. Namely the identification, monetization and risk management of market inefficiencies, anomalies and mispricings. That's as good a hedge fund definition as any. Given the trade secrets involved in the best arbitrage trades one wonders how hedge fund "replication" can offer much value. Most arbs are not easy to find or exploit which creates high barriers to entry. Interesting how arbitrage wasn't among the list of misunderstood terms in a recent survey of hedge fund definitions. Much arbitrage is really spread trading. Some spreads are reliable but many more others are as risky as the outright position.
The inspiration for this post came from my wandering over to pick up some arbitrage profits that had been lying in the corner courtesy of the ISE. Having designed highly profitablevolatility arbitrage strategies and the current options trading boom it seemed obvious that ISE would likely get bought out at a high premium. It was an "arb" because the acquisition value of ISE was clearly more than the value accorded it by "efficient" public markets. Ironically the calls on ISE itself were massively undervalued due to the marketmakers STILL using that idiotic Black-Scholes option mispricing formula.
If only it was always as easy as that. Most arbs are more difficult to identify. Good arbitrages are never signposted but they are out there and ALWAYS will be.
An academic metaphor is that if a $100 bill were dropped in the street then it would immediately be picked up therefore no arbitrage can exist or persist. But what if YOU happen to be the person that finds the note? Someone will. What if you specialize in walking the streets 24/7 looking for drops? What if you spent some of the "high" 2 and 20 fees on lots of employees and technology to monitor more streets in many other cities and countries?
What if you had the lowest latency execution and modeled trends and behavior so you could identify the streets with the highest probability of rewards. What if your costs are low enough that you can make a profit from picking up $10, $5 or $1 bills - even quarters? What if your computers are so quick they can catch the cash BEFORE it hits the ground? What if you monitored areas no-one else had thought to look? If you have the patience and resources there are plenty of arbs available on Wall Street just as money gets dropped in every streets each day.
Of course this can be taken too far and if the arbitrage becomes well known it becomes hazardous. Nickels in front of steamroller strategies are dumb deals where brash traders and incompetent Nobel laureates risk their fund for 5 cents and end up getting crushed for billions. Arbitrages in the PUBLIC domain will inevitably disappear. Transparency is the enemy of arbitrage so opacity is essential. The arbs you want are $100 bills and no steamrollers in sight. The best trades are waiting until there is some easy money in a corner and just wandering over and picking it up.
There are several hedge fund arbitrage strategies of which statistical arb, merger arb, fixed-income arb, capital structure arb, volatility arb and CB arb are perhaps the most well-known. Naive investors even think these are "non-directional" which is unfortunate as there is always some directional dependence inherent in a strategy. But within these categories there is a vast difference in the skill and methodologies by which these arbs are implemented. Probably only plain vanilla merger and CB arb are arbed out but even within those there is plenty of room to find non-vanilla opportunities. You just have to be VERY good at what you do. Better than 99% of other "professionals" in the strategy.
Some arbitrage amounts to short selling the liquid and going long the illiquid. That usually works fine in a bull market but can get hazardous when bearish times emerge. Some strategies have become so well-known that doing the opposite can make sense. REVERSE merger arb is betting on an announced deal NOT going through; spreads are so tight on most deals these days that the profits on one deal breaking can more than pay for other losses. REVERSE distressed debt is where you buy credit default options on "highly rated" securities likely to become credit impaired. Performed perfectly in the recent subprime mortgage and CDO debacle.
The carry trade whereby yen or swiss francs are borrowed and sold short and the proceeds invested in something with a higher yield is considered by some to be an arb. A common interest rate "arb" is borrowing short term to invest long term. There is a fair amount of commodities "arb" around playing contango and backwardation term structure. Activist equity and distressed debt hedge funds arb the difference between undervalued assets and their estimated true worth. Too many people have the carry trade on so REVERSE carry is NOW likely the best trade. Buy Japanese yen. NOW!
Lesser known but no less lucrative is model arbitrage. This is where a fund takes advantage of mispricings usually of fairly exotic derivatives and structured products. With counterparty global investment banks all keen to be seen at the "cutting edge" of financial engineering, their different models, software and underlying statistical assumptions can lead to pricing anomalies. It can be as basic as different interpolation methodologies of interest rate, credit and volatility term structures. Even a few basis points adds up when leverage, convexity and optionality get thrown in. Some providers don't seem able to measure correlation or credit risk correctly. Sometimes however the "error" is more subtle often involving stupid stochastic model based mumbo jumbo. A true quant is someone that arbitrages the other quants!
Other equity "market neutral" strategies are "analyst arbitrage" and "IPO arbitrage". A manager uses a carrot and stick approach to ensure they are the "first call" on sell-side analyst rating changes and to get into lucrative IPO allocations. Usually the carrot is paying high commissions and the stick is threatening to take their business elsewhere. There are several "hedge funds" around whose performance is NOT due to stock picking or trading ability but entirely due to their "skill" in analyst arb and brokers seeking favor by providing "market color" on other clients' positions and imminent transactions for front running. Is that skill? I don't think so and I don't allocate to those funds.
Algorithmic trading is so popular these days that arbing some of the more popular trade execution systems can work. Trend following has become so well known that arbing trend followers is possible; trends are readily identifiable therefore it is quite easy to know what positions certain funds have on. Once a particular trend ends, their behavior in exiting the trade can become predictable and exploitable. Again this is where black box trading systems must remain opaque otherwise performance will be temporary. Very temporary.
While the dictionaries need to be updated and the academics educated, arbitrage could be considered to form the basis of everything a true hedge fund does. Namely the identification, monetization and risk management of market inefficiencies, anomalies and mispricings. That's as good a hedge fund definition as any. Given the trade secrets involved in the best arbitrage trades one wonders how hedge fund "replication" can offer much value. Most arbs are not easy to find or exploit which creates high barriers to entry. Interesting how arbitrage wasn't among the list of misunderstood terms in a recent survey of hedge fund definitions. Much arbitrage is really spread trading. Some spreads are reliable but many more others are as risky as the outright position.
The inspiration for this post came from my wandering over to pick up some arbitrage profits that had been lying in the corner courtesy of the ISE. Having designed highly profitablevolatility arbitrage strategies and the current options trading boom it seemed obvious that ISE would likely get bought out at a high premium. It was an "arb" because the acquisition value of ISE was clearly more than the value accorded it by "efficient" public markets. Ironically the calls on ISE itself were massively undervalued due to the marketmakers STILL using that idiotic Black-Scholes option mispricing formula.
If only it was always as easy as that. Most arbs are more difficult to identify. Good arbitrages are never signposted but they are out there and ALWAYS will be.
© POSTED BY VERYAN ALLEN ON 30.4.07 
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