Session 29 (of 42): Not riskless, not even close - Pseudo or Speculative Arbitrage

0:01 Hi, welcome back. In the first session on arbitrage, I talked about the promise of arbitrage, the fact that you can take no risk, invest no money, and walk away with a sure profit. That's alluring, right? And not surprisingly, people trying to sell investment strategies have discovered that calling it arbitrage makes it more sellable. In this session, I want to talk about what I call pseudo or speculative arbitrage, which is really not arbitrage at all. It's just a risky investment strategy. It doesn't have to be a bad one. It could be a good one. But the word arbitrage here doesn't fit because these strategies actually expose their investors to lots of risk. So, you're saying, "Why would people use the word arbitrage to describe them?" As I mentioned, it's because the people selling these strategies have either deluded themselves into believing these strategies are riskless, or they've they want to delude others into believing they're riskless. The truth is, these are risky strategies. Sooner the people using these strategies accept that, the healthier their investing will be in this space.

1:04 So, let's look at some examples. The first is what's called paired arbitrage. Some of you might have read about Long-Term Capital Management. This is a This is an entity that was created in the 1990s with stellar credentials. John Meriwether came from Salomon, where he built this great fixed income business, and he brought in, you know, two Nobel Prize winners, and Bob Merton, and Myron Scholes, and created Long-Term Capital Management. The promise was, "We have the smartest people in finance in our midst, and we're going to find sure profits to make."

1:41 One of the strategies that they adopted to kind of to allow for the fact that they were growing, and a lot of money was coming in, was paired arbitrage. You're saying, "What's paired arbitrage?" You take two stocks that have historically moved together. Let's take an example that in the US in the 20th century had resonance. GM and Ford, the two largest automobile companies in the US for much of the 20th century. And over much of the 20th century, they moved in a in a way that was fairly predictable. GM traded at a higher PE ratio than Ford and lots of good reasons were given.

2:15 But they had a ratio of prices that stayed pretty stable over time. So here's how paired arbitrage works. You have two stocks that have moved, let's say in a two to one ratio for the last so GM trades at twice Ford and it's done it for the last 50 years. If GM trades at two and a half times Ford today, you argue that GM is overvalued relative to Ford and you carry through. You buy Ford, you sell GM and you hope for convergence.

2:43 You can already see paired arbitrage is ultimately built on mean reversion. Not just in one stock, but in two stocks moving together. And historically, the conventional practice is to look at stocks that are in the same business that have been tied together and look at the data to see what that pattern is. Already, you can see that paired arbitrage is not a riskless strategy. It has worked on average so studies suggest that it works. But the returns you make are relatively small. Okay? They in fact, in a one study looked at finding a magic partner for each stock just based in the data by looking at how they move together. They paired the stocks with the smallest at the highest correlation with each other.

3:27 And over a 15-year period, this strategy seemed to earn significant returns, an excess return of about 6%. Again, not mind-blowing, but well, you know, that's still it's you're not going to sneeze at it. That's a pretty good excess return. And so at least on paper, it looked like paired stocks strategies work. So what can go wrong? First is it is not a riskless strategy. It's risky because you're building it on mean reversion and history repeating itself, and history doesn't always repeat itself. In fact, staying with a long-term capital management story, long-term capital management blew up partly because their paired stocks strategy blew up. Things that they thought would move together stopped moving together.

4:12 And as as people you know, jumped onto the bandwagon and tried the same strategy, trying the it's the profit seemed to wear off. So, very quickly, you know, the excess returns you saw start to wear off over time. So, paired stock stocks strategy taking two companies that have historically moved together in a ratio that has been predictable, and you've tried to take advantage of it when that when the actual ratio deviates from that predictable ratio. But, you're built on mean reversion, and that stops working, you're going to lose money.

4:46 Let's move on to merger arbitrage. Again, a massive misuse of the word arbitrage. What's merger arbitrage? Earlier in the session, we looked at what happens around acquisitions, right? There's a target company, there's an acquiring company. The acquiring company comes in and makes its acquisition bid, and the target company stock price jumps on the announcement. But, it turns out it doesn't jump all the way up to the price that the acquiring company is offering. So, when an acquiring company offers a $50 price, the target company will often go to 46 or 47, not all the way to 50. Why? Because there's a chance that the merger might not work, and investors hold back.

5:27 Merger arbitrage is built on that fact. That there's a drift between what happens right after the announcement and the eventual price. You're still making a bet that the merger will succeed. And if you're good about picking the mergers that you know are going to succeed, then you will make money as the stock goes from 47 to 50, the target company's stock price. In a more sophisticated variant where you have share exchanges, where you have the acquiring company and the target company shares come into play because two shares of the acquiring company going to go pay for a share, merger arbitrage, you might buy shares in both companies and try to take advantage of the combined value going up as the uncertainty about the merger disappears. But ultimately, merger arbitrage is a bet on mergers being consummated.

6:17 Again, if you look at studies, one study looked at 4,750 mergers and concluded that merger arbitrage generated returns. So basically, on these mergers, they looked at what would happen if you bought the target company at the the price right right after the acquisition announcement and waited and collected. They said, "Even allowing for failures, you make a 9.25% return over and above what you need to." But if you bring in the effect of transactions causing the price impact, you have about 2/3 of those returns disappear. So it's a pretty modest excess return.

6:52 But here's the bigger problem. When there's a failure, a merger falls apart, and some mergers do, these strategies create very large negative returns. That's something you're going to notice with all of these speculative arbitrage strategies. They work most of the time, but when they fail, they have big negative payoffs. The reason that's relevant is you can do a study of these strategies and they might work and work and work, and over the 5 years you looked at them, they earned great returns.

7:23 But the sixth year, that catastrophic event happens and wipes out all of the money you made over the 5 years. So if you look at success at speculative arbitrage, one of the keys, I think, is to be careful about how much debt to use. If you remember pure arbitrage, you borrowed all of the money you needed to buy buy something. Why? Because there's no risk. It doesn't matter that you borrow 100% whether it's a futures arbitrage or an or replicating option arbitrage.

7:54 Borrowing is riskless because you created a riskless strategy. If you create a risky strategy, you might not be able to borrow 100%, 90%. We might not be able to borrow any money if it's a risky enough strategy. One of the reasons again Long-Term Capital Management failed was not just that fair paired no fair trading didn't work, but that they borrowed way too much money to fund a strategy as risky as pair trading. So, when it gets to near and speculative arbitrage, I think you have to adjust your leverage.

8:29 And to make money, you got to make sure you don't have a market impact as you do all of this. So, when you try to go out there and in the process of trying to take advantage of a mispricing, you push up the price of whatever you're trying to buy or push down the price of whatever you're trying to sell. You can very quickly wipe out the profits you make. So, this might be a philosophy that works better for a small fund, somebody with a limited amount of capital. It might not work as you scale up. And again, going back to Long-Term Capital Management, one reason I think they failed is they got too big.

9:04 And once you get bigger, you start to have a market impact and that very quickly can wipe out your profits. Now, to complete this process of arbitrage, even though it doesn't quite fit, I'm going to bring in hedge funds. What can hedge funds do that traditional mutual funds cannot? I think the biggest difference, and if you're truly a hedge fund, you should be exploiting this difference, is you can both go long, buy, and sell short. Traditional mutual funds can't sell short. So, to the extent that you can go long and sell short, hedge funds at least have the the of creating positions that if not riskless are very low risk because you're both long and short in investments.

9:44 And within hedge funds you have a huge range of hedge funds. Some bet on macro events, some bet on micro, some do value growth. So you can take every single investment philosophy we've talked about so far in this class and create a hedge fund around it. So let's look at hedge funds and the early promise that drives so much of why people hold them in such high regard. Early in the process, hedge funds and hedge funds are not new to the market. They've come and gone and there's some lessons in history from why they've gone.

10:16 I mean hedge funds exist in the early part of the 1900s but then you know big collapses and then they went away, they came back again. And in their most least recent iteration at least early on it looked like hedge funds were delivering a payoff. And what were not because they earned higher returns than traditional mutual funds but because of the risk return trade-off that they delivered which was better than the risk and return you would make by just investing your money in stocks.

10:46 So for instance, if you look at this study of hedge funds in their early years, the average return you earned on hedge funds was only 13.26% you think what do you mean only 13.26%? That was actually lower than somebody put their money in the S&P 500. Saying why would I then invest in hedge funds? Because it turns out that while the return was lower, they also had a much lower standard deviation in returns than the S&P 500. Remember we talked about Sharpe ratios? You take the return and divide by the standard deviation. If you compute the Sharpe ratios for hedge funds, 13.26 / 9.07, that's a much better Sharpe ratio than what you get for the S&P 500.

11:26 That's always been the sales pitch for hedge funds. Not that they deliver higher absolute returns but that they deliver much better trade-offs in terms of return and risk. The catch though is hedge funds also have astoundingly high costs. Many hedge funds follow what's called the two and 20, which means they take 2% of your money every year and 20% of the upside. If you bring in those fees and costs, it's not clear even these big payoffs last, but that's something to factor in.

11:58 Now, if you look across categories that return risk trade-off, you know, the gross return net returns vary across categories, but what they all share in common is a sales pitch, which is we can get you these returns with much lower risk than going into a long only strategy. Now, let's look at hedge funds a little closer to see what it is you might have to worry about if you're an investor thinking about putting your money in hedge funds. It's true. They offer much better risk return risk trade-offs, and this has been pretty much the case in every study of hedge funds.

12:32 But there's a significant survival risk that if you don't factor in, will bias you towards finding hedge funds to be better investors than they truly are. What am I talking about? A bad mutual fund can stay bad and not go away. A bad hedge fund goes away. The way this shows up in studies, if I look at existing hedge funds and work backwards, I will overstate the returns of hedge funds. Why? Cuz to see what hedge funds made over the last 5 years, I need to go back in time 5 years ago, put my money in hedge funds as they existed then, and allow for the fact that hedge funds that die are the ones where I will lose the most money. This is survival issue with hedge funds.

13:12 And if you factor in that survival issue, and the fact that hedge funds have become so much bigger in terms of money they invest, a reality check is coming into play. Remember we talked about alphas, what you earn over and above. Even allowing for the fact that hedge funds might deliver less risk than traditional funds, and you calculate the alpha based on that lower risk, the alphas of hedge funds have been on a downward trend for a long time.

13:40 In fact, for the last decade, you cannot reject the hypothesis that the alphas of hedge funds have dropped to zero. You say, "Why is this happening?" Again, imitation. Lots of capital coming in is wiping out the excess returns with hedge funds. If you remember, we discovered the same phenomenon with private equity. Two of the pillars of alternative investing have seen their alphas decrease over time because of more money coming in. So, let's summarize what we've learned with arbitrage.

14:11 Arbitrage can take three forms. It can be pure arbitrage, where you have two assets exactly the same cash flows trading at different prices. They can borrow 100%, lock in the profit, you have pure arbitrage profits. That's great, but it's rare, and it doesn't last very long. Near arbitrage is more common, but near arbitrage comes with some risk, and you got to adjust for that when you borrow money. And there can be that some risk, and sometimes blow up on you. And pseudo arbitrage is really not arbitrage. I don't even know why we attach the term arbitrage for it.

14:46 It's just risky strategies. They might be good risky strategies. They might deliver returns that justify the risk, but arbitrage doesn't belong in here. Hedge funds, in theory, could do arbitrage, but in practice, they don't. They have lower risk strategies coming from the fact that they can sell short. And at least, over time, we've discovered their alphas have decreased as they become bigger, and become more difficult for you to create excess returns. So, I hope you found this session useful, and I thank you very much for listening.