Hedge Funds Serve God And Mammon: And Lose

by Carla Johnson, Investors Offshore, London

21 February 2002

At a London conference this week hedge fund consultants Capital Market Risk Advisors(CMRA) announced the results of a survey which shows that merger arbitrage funds have posted significantly worse results than they might have done had they stuck to their last. The survey suggests that the risk-adjusted returns of merger arbitrage funds have suffered because of 'drifting' by the managers. 'Style-drifting' as it's sometimes called means managers flip-flopping out of their area of expertise and skill set because of a lack of opportunities within their defined style.

Merger arbitrage funds speculate on the outcome of proposed company mergers, making bets against the target company if they believe the deal will fall through or buying its shares if they think the merger will be completed. One area of style drift appears to be out of merger arbitrage into distressed securities, industry executives attending the conference told Reuters.

Virgina Reynolds Parker, president of U.S.-based Parker Global Strategies which is a manager of managers for hedge funds, said a number of merger arbitrage funds in the market were currently known to be carrying long equity positions. "If this was the case with one of our funds, we would fire the manager because we would like to see the manager operate in the same strategy we originally hired him for,'' she said.

The CMRA survey said the merger arbitrage strategy in general offered an attractive risk-return performance thanks to the modest returns these managers generate and their low volatility. This profile is put at risk when managers drift off into riskier, if more profitable strategies.

Based on performance data from Hedge Fund Research, merger arbitrage strategy generated an annualised gross return of 10.8% in the period between January 1997 and October 2001, mainly driven by higher returns on smaller deals which generated the highest returns, CMRA said. But when a conservative estimate of transaction costs and hedge fund fees are taken into account, the CMRA said the net return on merger arbitrage strategies was just 6.8 percent for the period between January 1997 and October 2001, lower than would be expected if the managers had stuck to a pure merger arbitrage style.

CMRA's survey found high correlation between pure merger arbitrage strategies and the Standard & Poor Index between December 1996 and March 2000 but low correlation beginning from October 2000. Zooming in on the financial market crisis period of September 2001, the survey said the pure merger arbitrage strategy delivered a positive return of 2.5 percent while the Hedge Fund Research merger arbitrage index fell three percent and the S&P fell 8.2 percent.

"Clearly, managers were playing the equity market significantly more than they were playing a 'pure' strategy,'' CMRA said.

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