Arbitrage funds continue to struggle, while distressed debt managers have mostly seen success. According to Kevin Campbell, v.p. at Van Hedge Fund Advisors International, the fixed-income arbitrage funds have performed poorly from January of 2004 all the way to June of 2005. Van Hedge defines fixed income arbitrage as arbitrage funds taking positions in assets such as mortgage backed securities and their derivatives.
Arbitrage funds had historically been one of the most consistent performers on the market, according to the firms' convertible arb index. From the period beginning in January 1995 until December 2003, funds saw annual returns of around 15%, with the worst returns in the period being -3.8%. In this recent 18-month down period, the total returns have been -5.2% with an annualized loss of -3.5%. The worst loss in the period was -8.5%.
"It wasn't one thing that led to this down period for arbitrage funds, it was more of a confluence of events," explains Campbell. In 2004, the total return on the funds was lower than expected. This led to many investors pulling out of the funds, which in turn led to the liquidation of portfolios, more redemptions and further problems arising with the pricing. Furthermore, very tight credit spreads are a driver of this market. When spreads widened, it had a huge impact on the market and caused volatility to be at a multi-year low. "Since the returns on the funds were the worst from March to May, when they went down 6.1%, you can never discount the affect that the General Motors situation had on the market," commented Campbell.
On the opposite end of the spectrum, the Van Hedge index has seen distressed debt funds rise 2.4% year to date. Managers at Van Hedge see the reasoning behind the surge lying in a strong demand for higher yielding investments, which tightened credit spreads. Campbell says that the restructuring of Enron may also have weighted on investors minds as they looked for profitable investment opportunities. "It's been a case of a greater demand for high yield than there was supply," he added.
Campbell also noted that many managers are remaining set in their strategies, but he has seen many opening new funds in order to take advantage of the distressed debt market while not pulling out of their arbitrage funds. In the month of June arbitrage funds rebounded slightly, up 1.3%.