By Ted Katramados, Director & Associate Portfolio Manager, TAG Relative Value Fund
One of the key cornerstones of TAG’s investment philosophy is Absolute Return investing. As we’ve previously discussed, Absolute Return investing is an essential strategy to decouple portfolios from the direction of the general equity and debt markets. The goal of Absolute Return investments is to yield a positive result no matter what the overall markets look like.
Over the next several quarters, we will periodically publish pieces focused on each of the main components of our Absolute Return investment strategy. Those components are:
- Arbitrage
- Global Macro
- Equity Market Neutral
- Esoteric Strategies
Part 1: Arbitrage
Arbitrage investing is a strategy designed to exploit price discrepancies between related assets. While the core principle remains the same—capitalizing on market inefficiencies—there are various approaches, each with its own nuances and opportunities.
There are four types of arbitrage investing that we focus on: Merger Arbitrage, Convertible Arbitrage, Volatility Arbitrage, and Fixed Income Arbitrage. Below is an overview of each of their mechanisms, relevance, and strategic considerations.
- Merger Arbitrage
Merger arbitrage seeks to exploit price discrepancies arising from corporate mergers and acquisitions. In a merger arbitrage scenario, an investor will take a long position in the stock of the acquisition target and a short position in the stock of the acquiring company. This is based on the expectation that the target’s share price will converge with the acquirer’s offer price once the deal closes.
The risk is that one broken deal can erase the profits from several successful deals. Although merger arbitrage was once more prominent, its significance has diminished somewhat in the face of increased regulatory activity, the complexity of deals, and the popularity of the strategy, which can reduce opportunity by diminishing merger spreads.
For example, in 2022, Microsoft announced its plans to acquire Activision Blizzard, which was trading at about $65 per share. Microsoft offered $95 and, in response to this offer, Activision-Blizzard’s stock price rose to around $80-$85. In many cases, there is a difference between the current stock price and what the announced price of the acquisition is. This “spread” between offer price and trading price exists because of uncertainty that the deal will close and the expected time it takes to close. The spread is the arbitrageur’s opportunity.
- Convertible Arbitrage
Convertible Arbitrage involves exploiting price differences between related financial instruments, sometimes using different parts of a company’s capital structure to exploit inefficiencies.
A convertible bond is a bond with an option to buy the company’s stock as well, often at a much higher price than when issued. This strategy involves purchasing convertible bonds while simultaneously shorting the underlying stock. The idea is to profit from the relative price movements between the convertible bond and the underlying equity.
The strategy creates a stock market-neutral position where the investor aims to profit from the bond’s price relative to the underlying stock. The bond provides a fixed income component (yield) while active trading of the equity short provides a play on the volatility of the underlying stock. This form of arbitrage has become less prominent in recent years due to market crowding, low volatility, and concerns about credit risk of the underlying issuers. But by virtue of falling out of favor, it has become more attractive once again.
In February 2022, Snapchat closed a private placement of $1.5 billion in convertible bonds due in 2028, with an interest rate of 0.125 percent per year. The 2028 Bonds were convertible into shares at an initial conversion price of approximately $56.34 per share. When Snapchat stock fell in 2022, convertible arbitrageurs were able to make handsome profits by owning the convertible bonds while simultaneously shorting the stock as the stock price fell by more than the bond price.
A related strategy to convertible arbitrage is capital structure arbitrage, where investors can be long the bonds of a company while short the stock. Another variation would be long senior secured debt and short subordinated debt. Both seek to profit from volatility in a company’s capital structure.
- Volatility Arbitrage
Volatility arbitrage is a more sophisticated strategy focused on exploiting price discrepancies between different equity options. This approach involves being long options that are perceived to be undervalued and short options that are considered overvalued, often in the same company, based on theoretical models of volatility.
Traders use mathematical models and sophisticated algorithms to identify options that are trading at a discount relative to their predicted volatility and vice versa.
Measuring the volatility of an asset is a little more complex than just looking at the volatility and saying, “is the number big?” That’s because every underlying stock is different. For instance, in October 2023, Disney options carried a volatility of 41%. That’s pretty high for Disney. At the same time, Tesla options expiring on the same date carried a volatility of 64%, which is actually quite low for them. In this example, a volatility arbitrageur could buy Tesla options and short Disney options, betting on volatility in the respective stocks to return to average levels.
The strategy is particularly relevant in volatile markets where discrepancies between implied and realized volatility can offer more opportunity. The volatility experienced in financial markets in periods such as 2018, 2020, and 2022 has made it a strong strategy for investors.
- Fixed Income Arbitrage
Fixed income arbitrage is a strategy centered around exploiting price inefficiencies between related fixed income securities. This involves trading cash bonds against interest rate swaps or futures contracts to take advantage of pricing discrepancies.
One common approach is the basis trade, where an investor might go long a U.S. Treasury bond while shorting a futures contract on the same bond, i.e. a standardized agreement to buy or sell U.S. government bonds or notes at a future date. The rationale is that the price difference between the cash bond and the futures contract will converge as the contract approaches expiration. Other strategies within fixed income arbitrage include trading different maturities of bonds or executing yield curve trades based on expectations of future interest rate movements.
Getting more specific, exploiting the difference in prices between a Treasury security and a related Treasury futures contract – the so-called cash-futures basis – works by purchasing the asset that is relatively undervalued and selling the other in a bet that the prices will converge. Basis traders support Treasury market functioning by keeping the prices of Treasury futures near their fair value. However, the basis trade is typically highly leveraged, which can increase Treasury market fragility. Research has found that the rapid unwinding of basis trades by hedge funds contributed to the Treasury market stress in March 2020.
Fixed income arbitrage can be complex and risky. During periods of market stress, such as the Long-Term Capital Management (LTCM) crisis in 1998, the expected convergence of prices didn’t come to fruition, leading to significant losses for the hedge fund that reverberated around the world. Despite these risks, fixed income arbitrage is still very relevant due to the deep opportunity in price inefficiencies within bond markets.
There are other arbitrage strategies, though not quite as prevalent, including closed-end fund arbitrage, where one buys a closed-end fund trading at a big discount to the fund’s net asset value in anticipation of mean reversion to a historical discount level. Statistical arbitrage, which uses complex quantitative methods to find stocks to buy and sell against each other, is another example.
While some of these strategies have evolved or fluctuated in relevance, they continue to offer value and provide market neutral returns in the context of a broader Absolute Return portfolio.