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Number One Hedge Fund Strategy? Convertible Arbitrage

After a miserable 2008, hedge funds are rallying back this year. And no strategy has mounted a bigger comeback than convertible arbitrage, which is up 21.6% through the end of May, the EDHEC Risk and Asset Management Research Centre reported on June 18. That’s 4.4 percentage points better than its nearest competitor, emerging markets.

Convertible arbitrageurs try to profit from inefficiencies in the convertible bond market. As their name implies, convertible bonds are securities that can be converted from an interest paying debt instrument into common stock. The arbitrageurs try to find convertibles that are trading for less than the implied value of the current equity. They then buy the convertible, short the common and wait for prices to normalize. The bonds got wrecked in 2008 and the historical relationship between the stocks and the bonds broke down. As a result, the average convertible arbitrage hedge fund lost 24.4% in 2008. But the convertibles market has recovered this year and the bonds are up 19.3% year-to-date (though still down 22.4% for the past 12 months).

Retail investors don’t have to be shut out of the convertible game. Morningstar lists 18 convertible mutual funds and they’re up an average of 16% this year. Tops is Legg Mason Partners Convertible (SCVSX), which is up 32.7% this year. In 2008, however, it plummeted 42% and is still off 23.12% for the past 12 months. Although the Miller Convertible Fund (MCFAX) is up only 14% in 2009, it lost just 19% in 2008, making it a less volatile play.

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