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Arbitrage hedge fund

Arbitrage? There's more DUMB MONEY invested in the markets than ever before. So there are MORE opportunities for alpha. Economics professors claim there is no such thing as arbitrage as it supposedly would be copied and eliminated! They are wrong. If you have the work ethic, intelligence and resources there are many arbitrages on Wall Street.

A common metaphor is that if a $100 bill is dropped in the street it would immediately be picked up therefore no arbitrage can persist. But what if YOU are the person that finds it? Someone will. What if you specialize in walking the streets 24/7/365 looking for drops? What if you spent some of your "high" fees on skilled employees and sophisticated technology to monitor more streets in many cities and countries?

What if you had low latency execution and modeled behavior so you could identify the streets with the highest probability of high value drops? 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?

Nickels in front of steamroller strategies are silly ideas where "star" traders and Nobel laureates risk client capital for 5 cents and get crushed for billions. Arbitrages in the public domain do disappear. Transparency is the enemy of arbitrage. Opacity is essential. The arbs you want are $100 bills all over the ground and no steamrollers in sight. The best trades are waiting for easy money and just walking over and picking it up. Thanks to the passive mania there are many available but you have to be smart and quick to find them.

Skill and hard work are the edge. Secrecy, opacity and incentive fees keep the edge. NEVER invest with someone who isn't secretive. Avoid fund managers that appear in the media or don't charge performance fees. Just because 99.99% of financial "professionals" can't find good arbitrages, doesn't mean exploitable inefficiencies don't exist. THEY DO. Markets are very inefficient and many investors are predictably irrational so mispricings and anomalies reliably appear.

If an arbitrage becomes crowded it becomes hazardous. The risk/reward expectation changes from positive to negative. That is why demands for greater transparency are so dangerous. Sadly many weaker hedge funds in their craze for dumber money reveal far too much. Never invest in a hedge fund that reveals its positions to favored investors.

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 skilled 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 dangerous 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.

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 counterparties 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.

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 profitable volatility 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.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

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