Someone coming in at this point with completely targeted money, that cannot be touched until the trade is unwound at the end of a year, is going to profit at your expense. That person is going to buy the American XYZ stock at $100, sell it forward in Canada at $110, and collect the difference in a year, or actually in 11 months, since a month of your trade has already gone by. So without even having to borrow any money, they are going to make approximately the same return you originally had to borrow three times your capital to achieve. They’re most obliged to you.

Some of the details are a bit different, but by coming in now, you are a lot like the new buyer, getting far better returns without having to resort to leverage. Just think of the American stock one buys in the strategy as a convertible and the Canadian stock sold forward as a traditional underlying stock. The loss of the leveraged convertible-arbitrage hedge funds is your gain. Congratulations!

Some Scary Numbers and Where They Came From

According to one frequently-watched index, convertible-arbitrage funds were down 54% through that awful Thursday, November 20th, when stocks made 11-year lows. That may not be as jarring as it should, with stocks down by nearly half this year, but remember this: the 54% is AFTER the benefits of an offsetting stock hedge, and this strategy has long been billed as one that performs well in down equity markets (as it did in 2000-2002).

I suspect that many investors in the strategy, told we would have one of the worst stock markets in history, would have expected positive or flat returns. They would have been naïve, perhaps, but they would have expected it all the same.

Why were this year’s number so bad? We’ve already seen the culprits: deteriorating credit and leverage being unwound.

Over the period during which convertible arbitrage dropped by 54%, the Russell 2000 Index, which I think is the single best index for mirroring the stocks underlying the domestic converts market, was down 46%. Also over that period, the Vanguard Convertible Index, a decent if not ideal representation of unhedged convertible performance, fell by 38%.

Now let’s do some back-of-the-envelope math: given the enormity of these numbers, rough estimates will be more than adequate. As a general rule, at least up until now, a convertible-arbitrage fund would sell short roughly $0.50 worth of stock for each dollar of convertibles it owned. This would of course vary fund-by-fund, but it’s sufficient for this analysis.

Continuing the foundation, a typical fund would borrow about $2 for each $1 of its own capital. Now we can see where this year’s awful performance came from in a strategy that was supposed to be reasonably market-neutral.

Let’s start with the $1 of the fund’s own capital. It bought convertibles that fell, based on the Vanguard fund, by $0.38. Against that it was short $0.50 worth of stock, making back about $0.23 for a net loss of $0.15.

But of course, the fund also lost $0.15 on each of the dollars it borrowed, for a total loss of $0.45 on the $1 of starting capital, or a decline of 45%. The additional 9% of losses needed to get to the actual 54% decline in convertible arbitrage can be easily explained by the large representation of financials in the convertible market this year (relative to, say, the Russell 2000) and the collapse in their valuations.