Hedge Fund Rankings – Convertible Arbitrage Funds

September 14, 2010

Gordon Gecko was right about greed: It is good. Or at least it makes for a Wall Street movie sequel. Anxiety, on the other hand, is just boring. When investors are no longer feeling greedy but haven’t yet slipped into panic, things get tedious.

The good news about this month’s emerging funds ranking is that the numbers are all still positive. In the convertible arbitrage category, we’re seeing the double-digit returns for the Top 8. But this is good news only in the face of diminished expectations. A few years ago, you had to look pretty far down the list to see funds with returns in the teens and twenties but at least today’s Top 10 is still making money.

What they’re not doing is taking a lot of risks. The S&P 500 has a Sharpe ratio, long-term, of about 0.41 (10% annual return less 3.5% risk-free rate, divided by 16% standard deviation). This year’s top-performing emerging funds have reward-to-variability numbers an order of magnitude higher. Some of this has to do with the cratering of the risk-free rate in these days of historically low interest on the T-bill rate, which is about one-third lower today than it is in flush times.

More of it, though, has to do with the low volatility of the instruments wherein these funds are parking their money. If the credit default swap was the 180-proof bathtub gin that gave the economy a hangover after a fifteen-year binge, then the morning after’s Bloody Mary is the convertible bond. These securities, which pay a fixed interest rate no matter how low they go but offer all the upside of common stock if they hit rise to their strike price, are built for safety. If you wear a belt and suspenders, carry an umbrella every day and shudder at the risk inherent in utility stocks, convertible bonds are for you. If you’re the one who manages a convertible bond fund, then you’re like the guy who sells umbrellas outside Penn Station every day — but right now it’s that rainy morning rush hour you live for.

Anxiety can’t last forever, though. Sooner rather than later, investors will return to either greed or fear. There will always be a market for and a need for convertible bond funds, but don’t count on them to remain high fliers for long.

SkyRank’s patented ranking system is a simple, transparent hedge fund rating methodology rewarding established funds that deliver high risk-adjusted returns.

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