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New Year’s Resolution: Diversification with Arbitrage

 

I’m a big fan of the AQR Diversified Arbitrage fund (MUTF:ADAIX). As a traditional ‘60/40’ investment manager, I started looking at the mutual funds and ETFs that pursue alternative strategies about two years ago. The market for these funds is rapidly growing with new entrants and large asset flows, but my favorite is still ADAIX, which is the only alternative mutual fund on our firms ‘Approved List.’
ADAIX invests in three types of arbitrage strategies to capture a liquidity premium that is generally not associated with stock or bond market returns. The first strategy is merger arbitrage which seeks to profit from the discount between the market price and the closing price in an announced merger. The second strategy, convertible bond arbitrage relies on the illiquid nature of convertible bonds that trade at a discount to their straight bond and option values. The third strategy, event arbitrage, is actually a collection of strategies such as duel-class, when-issued, stub-stock arbitrage, as well as various other miscellaneous ‘event’ related strategies.
Last year was a good year for ADAIX. Although the fund got off to a slow start (the fund was only up 0.73 percent through the end of June), the fund enjoyed a nice run in the second half of the year, and overall, the fund performed exactly as advertised.
The stated goal for the fund is to ‘seek long-term positive absolute returns and although AQR uses the Merrill Lynch three-month Treasury bill index as their benchmark, AQR has stated that their long run expectations for the fund are to earn the risk free rate plus 400 basis points per year on average.
In 2010, the risk free rate returned 10 basis points, so ADAIX handily beat their benchmark with a total return of 4.67 percent. While this was less than both stocks (15.04 percent for the S&P 500) and bonds (6.56 percent for the BarCap Aggregate), ADAIX achieved other stated goals that makes the fund attractive.
First, the fund had very low volatility. Measured on a monthly basis, the standard deviation for the fund was 0.65 percent, or 4.67 percent on an annualized basis. This was much lower than the volatility for stocks, which was 5.56 percent monthly, or 19.26 percent annualized. Interestingly, it was also lower than bonds, which had a standard deviation of 0.84 percent monthly, or 6.56 percent annualized. Thanks to the low volatility, ADAIX had an attractive Sharpe Ratio of 0.58, compared to 0.21 for stocks and 0.62 for bonds. 
There is no doubt that bonds had a terrific year in nominal and risk-adjusted terms. The last two months, however, when the yield on the ten year jumped 70 basis points and the BarCap Aggregate fell 1.64 percent, ADAIX gained 1.04 percent demonstrating its lack of sensitivity to interest rates. If you believe interest rates are set to rise in the future, bonds may struggle to maintain such great results.
Second, ADAIX had low correlations compared to stocks and bonds. Using monthly data, the correlation between ADAIX and stocks was 0.34. The correlation between ADAIX and the BarCap Aggregate was 0.02. Any alternative investment should be lowly correlated to stocks and bonds to achieve the benefit of diversification.
The low volatility and correlation along with the positive results could have improved the risk/return profile of a standard 60/40 portfolio. The return for the 60/40 portfolio using the S&P 500 and the BarCap Aggregate and rebalanced monthly was 12.12 percent. The annualized volatility was 10.92 percent for a Sharpe Ratio of 1.10.
If the stock and bond allocation were each reduced at the beginning of last year by five percentage points to create a ten percent diversified arbitrage allocation, the Sharpe Ratio for the new 55/35/10 stock/bond/arbitrage portfolio increased to 1.13. The returned dropped to 11.48 percent, but the volatility dropped by a greater margin to 10.12 percent, which allowed the risk-adjusted profile to increase.
There are 18 distinct mutual funds that Morningstar categorizes as ‘market neutral’ with had a complete track record in 2010, which includes several arbitrage funds. The range of results for such a small category is surprisingly large, from down 10.25 percent for the Leuthold Hedged Equity (LHEIX) to positive 6.23 percent for the TFS Market Neutral (MUTF:TFSMX) fund. Of the 18 distinct funds, only six posted positive results and ADAIX had the second best result. 
AQR continued to deliver with their Diversified Arbitrage fund in 2010 after a very successful launch in 2009. For investors making a more diversified portfolio one of their resolutions in 2011, ADAIX could be a good fit.

David Ott is a founding partner of Acropolis Investment Management, LLC., a fee-only RIA based in St. Louis with $840 million in assets under management.  He is the head of the Investment Committee.  The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: David Ott owns ADAIX for himself and his clients and it is on the firms 'Approved List.' The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members.