The Arbitrage Fund (USD) gained 0.29% in December bringing the YTD return to 16.44%.
Followers of financial markets have got used to the notion that December will bring a rally. Not this year! Another round of concerns about the credit crisis especially in the US accompanied a series of announcements about US Banks seeking help from foreign investors to rebuild their capital resources. Why do they think they need so much additional capital? Markets have assumed, rightly in our view, that there is more trouble in store. We will circulate a more detailed analysis of our view of the prospects for 2008 shortly.
The portfolio withstood the turmoil well. Two thirds of the mangers reported a positive performance in the month. In November, one of our fixed income arb managers found that an established price relationship between linked securities was pushed to an extreme. His judgement was that the loss caused by this in November would unwind. In December the valuation linkage between the bonds reasserted itself and he made a handsome return in the process. The mortgage arb specialists made money as well. In merger arb, Deals worth $340bn were announced in the US, a run rate that is not much reduced from the monthly average in a year that saw deals announced worth $4.75 trillion. But the High Yield market is closed and Bank debt is much harder to come by. So merger spreads were marked down to reflect increased risk that deals may fail for lack of finance. Two of the three Merger specialists in the portfolio lost money. Convertible arbitrage produced mixed results and the equity pairs arb Manager produced a small profit.
A new theme was added to the portfolio for December, Instrument Arbitrage. A non US Company that seeks to make itself attractive to dollar based investors can arrange for its shares to be repackaged into a Depositary Receipt, either American (ADR) or Global (GDR). This enables investors to buy the shares in dollars and settle in New York or London rather than having to transact the investment in the country and currency of the Company’s origin. Suppose the Company in question is listed in Hong Kong. Its shares will then trade in HK in HK$ and in the US in US$. Depending on the strength of the demand in each centre, to keep the two prices in synch, arbitrageurs move shares between the two formats, HK Listed and ADR/GDR’s. It doesn’t matter whether there is more demand for locally listed stock or the version traded globally. What matters is that demand pressure varies enough to put the price relationship under stress. The manager we have added has spent the past 10 years working as a specialist in this type of Instrument Arbitrage. Until a year ago, he practised his craft at the Proprietary trading desk of one of the worlds largest Banks based in Hong Kong. Having tracked his progress as an independent operator, we have decided to add his fund to the portfolio from this month.