Lee Munson and Lorn Owen Davis provide independent fund research on AQR Diversified Arbitrage Fund (ADANX, ADAIX).

In this post-Madoff world, investors are not seeking hedge fund styled over-leveraging and high risk/return strategies. But this doesn’t mean that some of the classic strategies used by hedge funds aren’t useful for other investment vehicles, like mutual funds. AQR’s Diversified Arbitrage Fund (ADANX, ADAIX) allows an investor to have exposure to hedge fund strategies without the high risk of leveraging. Its objective is to provide long-term positive returns that are uncorrelated with the stock or bond markets. This is what Modern Portfolio Theory is supposed to be about: the non-correlation of assets. Not some sales pitch on how much you have in mid cap domestic value versus small cap international growth.

Let’s take a step back and understand why this topic is being discussed. Last year U.S. stock funds faced a withdrawal of $234 billion due to the recession and stock market crash, leading many mutual fund companies to create specialized funds to attract capital from investors fed up with buy and hope strategies. Hedge funds needed more inflows from other sources like retail investors to match the outflows from institutional investors who were losing their shirts on those same buy and hope mutual funds. Though a hedge fund is not required to register with the SEC and generally issues securities in private offerings to high net worth investors, they have realized that in order to attract retail investors it is necessary to register with the SEC and provide fee disclosure, following in mutual funds’ footsteps. Remember that a hedge fund is just a compensation scheme, not an investment strategy. However, some strategies like arbitrage or short selling have generally been done in a hedge fund structure instead of in a mutual fund structure.

Strategically, hedge funds traditionally have the ability to short securities and delve into options, practices that tend to require leveraging to get outsized gains. Hedge funds’ tactics, going long and short different asset classes, has allowed them to continue churning out positive returns throughout the market’s descent, and it is this ability to mix long and short exposure without the extra leveraging that a few mutual funds are mirroring. This has created stable funds with low correlation to stocks, a major selling point in the current market climate. Granted, this stability is only based on the past and can breakdown at any time.

We predict that this is the early onset of a new type of mutual fund and AQR Funds are early adaptors to this trend. On top of that, AQR Funds are managed by a team of academically esteemed portfolio managers who have years of experience researching these kinds of strategies. Through the language they employ it becomes apparent that they represent the academic status quo kind of institutional investors. Yes, this is actually a good trait when you are dealing with exotic alternative strategies. Mavericks in exotic theories need to check their guns at the door.

ADANX deals with arbitrage strategies in convertible bonds, stock mergers, and SPACs (Special Purpose Acquisition Companies). The management team of ADANX consistently seeks to take advantage of liquidity and deal failure risk premiums. In plain English, this means making low risk bets when companies get bought or stocks get mispriced. The key is to take the other side of the bet, or hedge, and still be able to make a small profit. The real challenge of managing the portfolio, and fee justification, is astutely allocating money in the different strategies by predicting what will be profitable in the future. Investors aren’t paying fees for the managers to competently trade the different strategies, their ability to do so is already assumed, and instead the fees are going toward the managers setting up the combination of strategies that will earn the most. The simplest way to weight each part is by how many deals are available for that strategy, but what we want to see is that if convertible arbitrage is beating mergers by a wide margin then there better be a materially higher percentage in the portfolio in it.

Since the inception of the fund, the portfolio managers have shifted from being more heavily in SPACs at 25% to betting on convertible arbitrage at 45.8% (as of 3/31). This is due to the influx of $3.5 billion worth of convertible bonds into the market, a number that surpasses the past eight months combined. Liquidity in the convertible bond market is beginning to recover though it isn’t reaching the levels that were seen when hedge funds were involved in jacking up prices through leveraging. This makes the spreads wider and allows ADANX to profit without using much leverage. It is encouraging to see that almost half of the portfolio is taking advantage of this timely opportunity versus some canned allocation model dreamt up in the halls of academia. You can also tell if the managers are alert if they lower the weighting of convertible arbitrage when spreads narrow.

Knowing the portfolio managers are at least competent to trade these strategies, it would be helpful to review how the strategies work. Beyond what is given in the prospectus, the portfolio managers of ADANX, Mark Mitchell and Todd Pulvino, gave a teleconference outlining the strategies and the minutiae that makes them work. Convertible bond arbitrage, the strategy with the largest position, takes advantage of price inefficiency stemming from illiquidity in the issuance of convertible bonds while hedging by shorting the underlying stock. Because convertible bonds are effectively a combination of a corporate bond and a call option, profit will be made if the convertible bond can be bought cheaper than the call option. But the size of the profit is further determined by the volatility of the stock, so convertible bond arbitragers are betting that the stock movements will be volatile allowing them to take profits on their shorts and when they convert the bond into equity as a call option. This is an effective strategy in the current market which has been unsettled and forced many companies to issue convertible bonds as a rapid way to raise capital.

Next is merger arbitrage, which has two subdivisions: cash or stock deals. In the case of a cash merger the strategy is to wait for a takeover to be announced and then buy shares of the target corporation, selling when it hits the price the acquiring corporation is paying per share. The risk for cash deals are whether the deal is delayed, renegotiated at a lower price, or not consummated. With a stock deal, one still buys the target corporations shares but also shorts the acquiring companies stock in proportion to the deal. This means one might be liable for dividends and thus would bring down the potential gains. There is added risk involved because it’s dealing with two securities as opposed to just one, though the assumption is that the two will be correlated to each other. It was noted in the teleconference that it helps an arbitrager to think as an insurance company when dealing with merger arbitrage, ensuring that the spreads you pick up are enough to compensate for losses from deals that fall through. In terms of the current market environment we’ll be seeing more intra-industry mergers as companies try to cut costs and consolidate.

The next major form of arbitrage that is featured by ADANX is event arbitrage through SPACs. SPACs are publicly traded companies that hold only one asset that is typically in a trust and acts like the reverse of an IPO because the manager actively seeks an operating company it can buy out with the trust and then manage, giving shareholders in the SPAC the ability either to hold shares in the new company or redeem their proportionate share of the trust. The nice thing about a SPAC is that the risk is similar to that of a Treasury bill because that’s really where your money is being held and can be pulled out at any time. So if the investor doesn’t like the company that is being proposed to be bought, there hasn’t been any loss of invested capital. It sounds easy, but just start reading the filings for SPAC’s and you will appreciate experience and careful analysis of each issue.

The last major strategy is closed-end fund arbitrage. A closed-end fund is a just like a regular mutual fund, but has a fixed number of shares. So, it can sell for over, or more likely, under the net asset value of the stocks or ‘stuff’ in it. An open-end or ‘regular’ mutual fund does not have a fixed number of shares and gets priced each day at its net asset value. An arbitrager that believes a closed-end fund is trading at a discount or a premium can jump in and try to capture the correction to a more accurate price for the fund. For example, a fund that’s primarily in bonds can be taken advantage of if the arbitrager believes interest rates to be shifting in the near future. The problem is that you never really know day by day what the closed end fund has in it. Like SPAC’s, you need to know what you are doing and be able to hedge yourself if the bet goes south. However, we are rather disappointed that they do not hedge, but just ‘buy them cheap’ at a discount. Not exactly a mind-blowing strategy so we hope they do not get to heavy in this pedestrian trade.

ADANX offers investors an opportunity to get involved in alternative strategies with one fund and little or no leverage. Their strategies operate on a short-term basis, usually with settlement dates or the completion of trades no longer than 60 days. So, you’re not betting on the buy and hope trade. Short time horizons mean more trades and the ability to preserve capital by not having to go over the rainbow on a multi-year market cycle in which you hope that the manager can make you money. If we see this fund failing, we will not, as most long-only managers would like, simply hold it and hope it comes back. They have a short leash on the portfolio; we have a short leash on them. So for the fee of 1.5% versus the standard 2% of assets and 20% of profits, you can have experienced arbitragers manage a few basic styles. AQR Funds is offering an excellent opportunity to catch the oncoming wave of mutual funds mimicking hedge funds with less offensive fees and leverage.

Tags: ADAIX, ADANX, AQR, closed-end fund, convertible bonds, Diversified Arbitrage Fund, hedge funds, IPO, Madoff, Mark Mitchell, mutual funds, SPACS, Special Purpose Acquisition Companies, Todd Pulvino