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are focused on absolute returns, or on returns relative to short-term inter-
est rates.
Arbitrage programs are about the closest to being market neutral.
They are especially dependent on the skills of their investor. Arbitrage
managers typically buy a portfolio of securities (they go long) and borrow
a similar portfolio of securities that they sell (sell short).
As a simplistic example, we might invest $100,000 in General Motors
stock and simultaneously borrow $100,000 worth of Ford stock and sell it
(sell it short). We would be as long as we are short, and we wouldn™t care if
the market went up or down, or whether automobile stocks performed
well or poorly relative to the market. We would care only about the perfor-
mance of GM stock relative to the performance of Ford.
Mechanically, such accounts use a sophisticated broker through whom
our manager buys our long portfolio and then borrows and sells our short
portfolio. The lender retains, as collateral, cash slightly exceeding proceeds
from the sale of our shorts and invests it in T-bills.1 Our arbitrage account
receives a portion of the interest on the T-bills”as much as 80%, depend-
ing on interest rates”and the lender retains the balance as his lending fee
and to pay brokerage costs.
Arbitrage accounts take many forms, and we will comment here only
on some of the more common ones.

Long/Short Stock Accounts
Nobel laureate Bill Sharpe, a leading proponent of index funds, has said
that a long/short strategy is his favorite active strategy.2
Conceptually, a long/short stock account is about the simplest arbi-
trage program”a long stock portfolio, and a short one. Most investors
cannot, net of fees, do as well as an index fund, which only buys stocks. A
long/short manager has the challenge of adding value both ways”long and
short, and he gets no bene¬t (or harm) from a move in the stock market.
Moreover, the fees for a long/short manager, as with all arbitrage man-
agers, are very high”a ¬xed fee of up to 1% of assets plus, typically, 15%
to 20% of net pro¬ts above T-bill rates! Obviously, one wants to consider
only an exceptional manager for such a task.

Short-term U.S. Treasury bills.
Peter J. Tanous, Investment Gurus, New York Institute of Finance, 1997, p. 104.
Liquid Alternative Assets

Caveat re short selling: Investors should be aware that short selling in-
curs risks beyond those of normal long purchases.

When we buy a stock, we can lose no more than the price of the

stock. When we sell a stock short, our losses are unlimited. If the
stock doubles in price, we would lose 100%. If it triples in price, we
would lose 200%!
The lender of the shares that we sell short can recall those shares at

any time. If we don™t return those shares promptly, he can purchase
them from the market at our expense. Shrewd traders may see an op-
portunity to buy shares of a thinly traded stock and drive up the price,
and then recall the loaned shares. This is known as a “short squeeze.”

Do these risks mean we shouldn™t get involved with short selling? No,
there can be too much value in short selling. But we do need to be extra
con¬dent in the competence of our managers who engage in short selling.
We might think of market-neutral long/short stock managers (ones
who are as long as they are short) as being generally one of three kinds:

1. The most conservative kind will take no risk in industries nor perhaps
in other common factors. If the investor buys a large pharmaceutical
company, he will sell another large pharmaceutical company”betting
on the spread between the two pharmaceutical stocks.
2. A second kind won™t pair stocks quite so explicitly but will ensure
that the aggregate characteristics of his long portfolio (such as
price/earnings ratio and earnings growth rates) are the same as those
of his short portfolio.
3. The third and most volatile kind tracks how large stocks are priced rel-
ative to small stocks, or how “growth stocks” are priced relative to
“value stocks,” or how one industry is priced relative to another. This
manager will buy a basketful of large growth stocks, for example, and
sell short a similar-size basketful of small value stocks.

Why is the return of such funds measured against T-bill rates? The
long/short fund earns much but not all of the T-bill return through, in ef-
fect, the investment of the proceeds from the short sales. Hence, any
long/short investor worth his salt should earn more than the T-bill rate.
What should we expect from a long/short stock account? With ex-
tremely good long/short stock funds we can earn 4 to 6 percentage points

more than T-bill rates. Volatility, while dramatically lower than for a regu-
lar common stock account, is still materially higher than for a money-mar-
ket fund. Correlation with the overall stock market is near zero.
A good long/short stock account should provide better returns than a
bond account, with possibly lower volatility and an even lower correlation
with the stock market than bonds have with the stock market. A long/short
account, like other arbitrage funds, can be used as a Portable Alpha. We™ll
discuss Portable Alphas after we ¬nish talking about arbitrage programs.

Merger and Acquisition (M&A) Arbitrage
An M&A arbitrage opportunity occurs when Company A bids to buy
Company B for $60 a share, compared with Company B™s current price of
$40. The price of Company B rapidly zooms closely to $60, but not all the
way. After all, it is not known whether Company B shareholders will ac-
cept that price, or whether the Federal Trade Commission will allow the
acquisition. Nor is it known how long it will take for the acquisition to be
consummated, if indeed it succeeds in going through. And if the stock mar-
ket should fall off a cliff, as it did in October 1987, the offer might be
This is where the M&A arbitrageur comes in. He assesses the proba-
bilities that the acquisition will take place and how long it will take, and he
offers to buy the stock of Company B for, say, $56 a share. Investors in
Company B are pleased with the run-up in price and may sell at that price.3
What™s in it for the arbitrageur? He buys at $56. If and when the ac-
quisition ultimately takes place he receives $60”a pro¬t of 4/56, or 7%. If
the acquisition takes place four months from now, his annualized rate of
return is 23% (1.0712/4 “ 1). Sounds easy. But if litigation should drag out
the acquisition for a full year, his annualized return is an unsatisfying 7%.
And if the deal breaks, and Company A does not acquire Company B after
all, then the price of Company B will probably plummet close to its origi-
nal $40 per share, and our arbitrageur will have lost 16/56, or 29%.
A good arbitrageur does a sophisticated job of assessing the risks of an

If the purchase won™t be for cash but will instead be for a certain number of Com-
pany A shares, then the arbitrageur sells short Company A. That way, the arbi-
trageur is insulated from market volatility. He is investing only in the spread
between the prices of Companies A and B. In such cases, do M&A arbitrageurs need
to sell short? They do unless they™re willing to take the risks of the stock market.
Liquid Alternative Assets

announced merger plan and thereby performs a useful function that the av-
erage common stock manager is not equipped to perform well.
Over the long term, good M&A arbitrageurs may earn net unlever-
aged returns of 4 to 5% in excess of T-bill rates for their investors. Returns
are in¬‚uenced by the level of T-bill rates, because investment bankers
sometimes use the less risky M&A arbitrages as an alternative investment
for their money-market accounts. Some arbitrageurs have had negative re-
turns in years when an unusually large number of deals broke (fell apart).
A reasonable expectation for the annual volatility of a good unlevered
M&A arbitrage program might be roughly 6%”about one-third that of a
typical common stock account. The correlation of most M&A arbitrage
programs with the stock market may be as high as 0.3.

Convertible Arbitrage
Good money can also be made by buying a convertible bond or convertible
preferred stock, whose interest coupon gives it a high yield, and simultane-
ously selling short the common stock into which the security can be con-
verted. The dividend rate on the common stock would normally provide a
much lower yield.
The arbitrageur thus invests in the spread between the interest rate on
the convertible and the dividend yield on the stock. But it is more compli-
cated than that. The arbitrageur may earn additional money if the price on
the stock declines, because the price of the convertible security is often un-
derpinned by its bond value. Conversely, if a convertible security is priced
at a premium above its conversion value (the value of the stock into which
it is convertible), and if the issuer of the convertible security should call
that security”that is, force its conversion into common stock”the arbi-
trageur would lose money.
Unfortunately, rates of return on convertible arbitrage are low, perhaps
only a few % higher than T-bill rates, unless the program is leveraged, in
which case it may provide low double digit returns.
For tax-exempt funds, however, leverage generally results in unrelated
business taxable income, which is taxable as UBIT at corporate rates. Can
we get around UBIT? Yes, it is possible, with the help of a tax lawyer. One
of the more common methods is to invest in an offshore fund, such as one
registered in Bermuda or the Cayman Islands.
A good, modestly leveraged convertible arbitrage program still has
modest volatility”perhaps 10% or less per year”and a low correlation
with the stock and bond markets.

Interest Rate Arbitrage
The spreads between two different interest rates vary over time. I™m refer-
ring to interest rate spreads such as those between long bonds and Trea-
sury bills, between corporate bonds and Treasury bonds of a similar
duration, or between mortgage-backed securities (like GNMAs) and Trea-
sury bonds. A manager may feel he has very little ability to predict the di-
rection of interest rates (few managers do), but he may be competent at
predicting the direction of certain interest rate spreads.
If so, he can capitalize on that expertise through a long/short portfolio,
which is indifferent to the direction of interest rates in general. He can, for
example, go long Treasuries and short mortgage-backed securities when he
believes the interest rate spread is too narrow and is likely to widen, and
vice versa when the spread seems too wide. Either way, he would be indif-
ferent to the direction of interest rates in general.
The manager, however, doesn™t make much money when he is right, nor
lose much money when he is wrong. He must leverage to make the effort
worthwhile. In some cases, he can invest as much as 10 times the net value
of the account in a long portfolio and an equal amount in a short portfolio
and still have only a relatively modest standard deviation of returns.
Leverage 10 times?! That sounds like rolling the dice”high returns or
disaster, and monumental volatility! Unfortunately, the word leverage is one
of those emotion-laden words that get in the way of real understanding. Un-
leveraged investments”as in a start-up company”can be extremely risky,
whereas a highly leveraged interest-rate arbitrage account may conceivably
be less risky than a standard unleveraged bond account. The point is this:
Leverage is not necessarily either good or bad. It all depends on how much
leverage is used, how it is used, the underlying volatility of the leveraged in-
vestment, and”of course”the expertise of the manager.
In 1999 a private sector group called the Counterparty Management
Policy Group issued a report to the SEC that said, in part, “The policy group
believes that leverage, while an extremely important concept with broad in-
tuitive appeal, is not an independent risk factor whose measure can provide
useful insights for risk managers. . . . Rather, leverage is best assessed by its
effects, which can be observed in the possible ampli¬cation of market risk,
funding liquidity risk and asset liquidity risk. . . . In a world of active portfo-
lio management, an increase in leverage may be associated with a decrease in
market risk.”4
Phyllis Feinberg, “Report Concludes Leverage Isn™t Independent Risk Factor,”
Pension & Investments, September 6, 1999.
Liquid Alternative Assets

As we mentioned before, leverage generally leads to Unrelated Busi-
ness Income Tax (UBIT). If we get over the UBIT hurdle with an interest-
rate arbitrage program, we should have an account that has essentially no
correlation with the ups and downs of either the stock or bond markets.
Will it make money for us? Only if we have a talented manager.

But wait a minute! What happened in September 1998 to Long-Term Cap-
ital Management, L.P., with its Nobel-prize-winning strategists? It nearly
went bankrupt and probably would have if the Federal Reserve had not
taken some action to generate a rescue. Long-Term Capital was perhaps
the ultimate arbitrageur. Doesn™t that mean that arbitrage is, in fact, an
area where mortals should fear to tread?
Long-Term Capital certainly gave arbitrage a bad name. But our con-
structive reaction should not be to shy away from sensible arbitrage strate-
gies but to learn from Long-Term Capital™s mistakes.
Long-Term Capital adopted a strategy I have urged throughout this
book to reduce risk”diversi¬cation. It scattered investments among a
great many kinds of arbitrage worldwide that have low correlations with
one another”low correlations over time, that is. It failed to remember that
on rare occasions, when panics occur in markets worldwide, no one wants
to buy anything that has even a semblance of perceived risk, and prices
plummet. Correlations among arbitrage strategies that are normally very
low suddenly zoom toward 1.0”as in a chain reaction.
Because natural market forces tend eventually to drive the spreads be-
ing arbitraged back to some semblance of normalcy, Long-Term Capital™s
strategy probably would not have been ¬‚awed if Long-Term Capital had
staying power to survive the liquidity crisis. But it didn™t.
Long-Term Capital had leveraged its entire $5 billion portfolio”not just
well-chosen parts of it”twenty-¬ve times! As prices fell, Long-Term Capital
received margin calls”demands from its brokers to increase its security de-
posits. Long-Term Capital had based its strategy on the expectation that it
could readily sell its holdings whenever it wished at reasonable prices. But
when it went to sell, it found markets had dried up for all but the highest
quality and most liquid investments. It was a time when virtually all arbi-
trageurs lost money”at least on paper”but they survived. Long-Term Cap-
ital, however, was forced to sell. Without an infusion of cash, Long-Term
Capital would have to realize such large losses that its total liabilities threat-
ened to exceed its total assets. That™s a de¬nition of the brink of bankruptcy.

So what™s the moral to the story? We should ask our adviser enough
questions to satisfy ourselves that the manager has the discipline and stay-
ing power to survive when markets suddenly become illiquid.

Managed Futures
To many investors, commodity futures5 seem like spinning a roulette
wheel. And clearly, that can be a good analogy. But it doesn™t have
to be.
We all too quickly associate commodity futures with pork bellies, one
of the least traded commodities. There are more than 50 exchange-traded
commodities worldwide, including metals, agricultural products, petro-
leum products, foreign currencies, and interest rate futures.
Most of those who trade commodity futures are hedgers, business-
people who are buying insurance. The farmer sells corn futures because
he can™t afford the risk of ¬‚uctuating corn prices at harvest time. The
importer buys futures on the Japanese yen because he can™t afford un-
predictable ¬‚uctuations in his cost of goods sold. Hedgers are not al-
ways in equilibrium. At times, more hedgers need to buy than to sell, or
vice versa.
For commodity markets, liquidity is provided by “speculators.” That™s
another emotion-laden word that gets in the way of real understanding.
Speculators serve a valuable economic function, and the best of them are
among the more quantitative academics in the investment world. They ab-
sorb the volatility in most commodity markets. They minimize their
volatility by investing in a wide range of commodities with little or no cor-
relation with one another, and they rationally expect to make a long-term
pro¬t on their investments.
The MLM Index of commodity futures, established at the beginning of
1988, provides perhaps the best evidence of how those insurance premi-
ums get realized.
The index is totally different from a stock or bond index. As reconsti-

An example of commodity futures would be a contract to buy an amount of corn
by a speci¬c date for $X/bushel. We can buy that future today and are betting that
we will be able to sell that future later for a higher price. We certainly don™t want
delivery of all that corn!
Liquid Alternative Assets

tuted in December 2004, the index records the returns on a portfolio of 22
different futures, which are divided into three baskets:

Commodities (11 futures)

Currencies (6 futures)

Bonds (5 futures)

These baskets are weighted by their relative historical volatility so that
each will have roughly equal impact on the index. Within each basket, the
futures are equal weighted. The portfolio of futures is rebalanced every 21
days under a simple mechanistic algorithm: If the current price of a future
is above its average over its 252-business-day moving average, the index
goes long that future; if it is below, the index goes short. The underlying
cash is invested in T-bills.
Since its 1988 inception, net of hypothetical fees and expenses of
nearly 2% per year, the index has provided a 7% return with a 6% volatil-
ity, and a negative .2 correlation with the S&P 500, and a positive .1 to .2
correlation with the Lehman Aggregate bond index.
If the index were leveraged three times, with commensurately higher
expenses, its net return since 1988 would have been 13%, with an annual
standard deviation of 18%, roughly the same as for common stocks”and
the same slightly negative correlations as the unleveraged index, promising
strong diversi¬cation bene¬ts.

Portable Alpha
Over longer intervals, arbitrage programs offer the attraction of a very low
correlation with other investments, but only the more exceptional ones can
be expected to provide the same high long-term returns as a common stock
account. It is nice to diversify, but I always hate to give up expected return
for the privilege of diversifying.
Well, here is a place where it is possible to have our cake and eat it
too”by combining an arbitrage program with an index fund (or a tactical
asset allocation account) that is invested entirely through the use of index
futures. We can invest in an S&P 500 index fund, for example, without
buying a single stock. We can match the index with great precision either
(a) by buying index futures and keeping our cash in a money-market fund
or (b) by swapping cash returns plus a few basis points for S&P returns.
We can then turn the index fund into an actively managed account by,

instead of investing our cash in a money market fund, putting it in any ar-
bitrage program that has low volatility and a low correlation with the
stock market. Why might we want to do that?
An exceptional manager of large common stocks, net of fees, might
over the long term be able to outperform the S&P 500 by 2 percentage
points a year, and a great bond manager might outperform a bond index
by 1 percentage point. But if we have a low-volatility arbitrage manager
who can be expected to outperform LIBOR by 3 or 4 percentage points per
year (after fees), we can pair him with a manager of index futures (without
either manager having to know he is so paired) and expect the index return
plus 3 or 4 percentage points, or more.
Don™t the combined accounts have a higher volatility than the index
fund? Yes, but not much higher if the arbitrage account is really market
Incidentally, why call it Portable Alpha? Because if we let alpha stand
for “excess return above our benchmark,” we can synthesize a high-alpha
bond or stock portfolio by investing in an arbitrage account (the source of
the alpha) and overlaying that account with index futures (the bench-
mark). We transport the arbitrageur™s alpha to a stock or bond account.
We can mix and match as we please with Portable Alphas.
Portable Alphas are not yet widely used by taxfree funds”perhaps be-
cause they are complex, offbeat, and dif¬cult for committee members to
grasp. That leaves all the more opportunity to those taxfree funds that are
enterprising and willing to open their minds.

Hedge Funds
The arbitrage programs described above are often included under the term
“hedge funds.” The Commonfund Benchmark Study includes them as
“hedge funds” when it shows that 28% of endowment funds of all sizes in-
vest in hedge funds.
But here I will use the term “hedge funds” to denote funds other than
those intended to be market neutral, to denote funds that are generally
more long than short. Even so, the term “hedge funds” covers a wide range
of investment approaches. Virtually all hedge funds sell stocks short as well
as have a normal “long” portfolio. That is where commonality ends. Some
are quite conservative. Others are highly leveraged to the markets. Most

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