Hedge Funds Cash Up As Investors Pull Out Of Convertible Funds

by Phillip Morton, Investors Offshore.com

19 May 2005

Hedge fund firms are bracing themselves for a period of heavy redemptions as investors stung by recent losses in the convertible arbitrage sector, traditionally one of the safest bets in the hedge fund arena, begin to pull money out of funds.

Convertible funds became all the rage after delivering returns of 28% in 1998. By the first quarter of 2005, total assets in the strategy had escalated to some $43 billion, according to Hedge Fund Research. However, as the market has become increasingly overcrowded with managers seeking inefficiencies in a market that has become increasingly more efficient, returns dropped to 10% in 2003, and a paltry 1% last year.

The strategy itself involves the purchase of convertible securities and the subsequent shorting of the corresponding stock. By doing so, the trader attempts to exploit profits when there is a pricing error made in the conversion factor of the convertible security, hence the strategy is dependent on pricing inefficiencies to make a return.

By early 2005, the strategy was beginning to lose; falling 3.13% during April, the convertible arbitrage funds in the CSFB/Tremont Hedge Fund Index are down 5.76% on a year-to-date basis. Convertible hedge funds tracked by the Van Global Hedge Fund Index lost 3.8% on average last month.

Reports suggest it likely that that these diminishing returns will lead to net outflows from convertible funds in the coming months, and hedge funds are being forced to cash out their existing positions in order to meet redemptions which, according to some analysts, could be the heaviest in ten years. This could also force many of the estimated 7,000 hedge fund firms out of the market altogether.

In the first quarter of 2005, investors had already pulled out about $1 billion from convertible funds, says HFR.

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