by Mike Schnitzel.
The AQR Diversified Arbitrage Funds, I Shares (ADAIX) is a top performer among Lipper Alternative Event Driven Funds using Lipper Leader metrics for the month ended October 31, 2022. The way the fund has managed such consistent returns through even turbulent markets includes the utilization of economic research, flexibility, and stringent risk management, according to lead portfolio manager Todd Pulvino, principal and co-founder of AQR’s arbitrage research affiliate AQR Arbitraged. We spoke with Pulvino to discern how ADAIX’s managers construct its portfolio and their views on arbitrage and investing in the Alternative Event Driven Funds classification.
Lipper Leaders Ratings and methodology
ADAIX earned a 5 for Consistent Return, Total Return, and Capital Preservation on a three-year basis. The fund also outperformed its benchmark, the ICE BofAML US Treasury Bill 3 Month Index, on a three-, five-, and 10-year basis. The Lipper Alternative Event Driven Funds classification are funds that, by prospectus language, seek to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition, or spinoff. Alternative Event Driven Funds can invest in equities, fixed income instruments (investment grade, high yield, bank debt, convertible debt, and distressed), options, and other derivatives.
The Lipper Leaders Rating System is a toolkit that helps guide investors and their advisors in selecting funds that suit individual investment styles and goals. According to Refinitiv Lipper, “Each fund is ranked against its peers based on the metric used (such as its flagship risk-adjusted return measure, Consistent Return, Total Return, or Expense), and the highest 20% of funds in each peer group are named Lipper Leaders, the next 20% receive a rating of 4, the middle 20% are rated 3, the next 20% are rated 2, and the lowest 20% are rated 1.”
Fund has origins in academic research, uses uncorrelated strategies
Pulvino said the overall philosophy of ADAIX stems from academic research he did as an associate professor of finance in the 1990s at Northwestern University’s Kellogg School of Management. Pulvino said he and his primary partner Mark Mitchell were both professors in the 1990s (Mitchell at Harvard University and the University of Chicago) and did research published in an academic journal. So, on September 1, 2001, with $25 million seed capital, they launched a merger arbitrage fund with AQR. “The economy went into recession after 9/11, and merger arbitrage activity dried up,” Pulvino said. “Being a siloed merger arbitrage fund wasn’t the way to go, so we did research on adding convertible arbitrage and then on various event driven strategies, which ultimately led to the launch of this fund in 2009.”
Pulvino explained that around corporate events there are capital flows in the market where a group of investors put a liquidity demand on the market. “When there is a merger announcement, legacy stockholders often want to sell, especially within a few days after the merger announcement because they don’t want to take the chance the merger will fail,” he said. “Arbitrageurs buy that target stock from legacy shareholders, stepping into a liquidity void to make a premium. This is why strategies like this generate an excess return.”
Pulvino said that even if you only provided liquidity in the normal course of events, there is a risk premium to be captured. However, when there is a significant event, security prices can be traded at a large discount to fundamental value.
The ability to be flexible helps ADAIX’s management to generate returns and limit losses in rough markets. “The strategies our fund uses—such as merger arbitrage, convertible arbitrage, and various event driven strategies—are not perfectly correlated with each other. We can move capital from whatever strategy is not attractive at the time to whatever strategy is. This causes returns to be a bit more stable than if we had a strictly focused fund.”
Managing from the ground up to find opportunities
ADAIX’s management manages the fund from the ground up as it chases opportunities. Pulvino said the managers of each strategy will either see an opportunity or they won’t, but if they do they will buy heavily and use leverage.
“With convertible arbitrage, you are trying to buy cheap securities. A convertible bond is a derivative security and derivative pricing models have developed to be quite accurate,” Pulvino said. “You can get pretty close to a theoretical value of a convertible bond. We then compare theoretical value to market price and when we find something in the universe that is well below theoretical values, then the guy running the convertible desk will be buying that bond, leading to a bigger weight on convertible arbitrage in the fund, so the strategy weights adapt to the opportunity set we’re seeing.”
One example of an opportunity that ADAIX pursued were Special Purpose Acquisition Companies (SPACs), which are used as IPO vehicles for private companies. “In 2009, we invested in SPACs and were able to get 12% premiums because SPACs were the cheapest source of liquidity for many funds during the financial crisis,” Pulvino said. “In addition, we were buying 20% of every SPAC IPO that came out then. We reacted to where the market was demanding liquidity and that’s where we went.”
Identifying and managing risk
Pulvino said there are three different types of risks ADAIX’s managers look to identify and manage. Firstly, there is cluster risk, which managers seek to identify and decrease weightings. For example, in 2010 and 2011 there were millions of Chinese convertible bonds issued that were brought to market by well-regarded investment banks but turned out to be fraudulent. Recourse as a bondholder in China is very difficult, so the managers of ADAIX saw these bonds as a unique cluster of risk. They limit the risk they take on identified clusters by downweighting them in the portfolio.
Another risk to keep an eye on is systematic risk. ADAIX uses data to determine the best way to reduce that exposure. Merger arbitrage has close to a zero beta, Pulvino said, but in a volatile market, merger arbitrage gives you positive beta. That is driven by financing contingent cash mergers. If the managers want to get rid of this systematic, down-market risk in the portfolio, they downweight LBO deals which may look otherwise attractive, but contribute to portfolio beta in an unattractive way.
Pulvino said the best way to manage idiosyncratic risk is to diversify your portfolio. Overall, ADAIX’s managers focus on the downside risk. “When we listen to conference calls after a merger where everyone is congratulating each other, we are thinking where the stock price could go if the merger fails,” he said. “Our calculus is to assume it does fail and then to calculate that loss and figure out how to mitigate it, so we have risk control on a position-by-position basis. The cheapest way to get rid of idiosyncratic risk is to diversify—that’s a free way to get rid of it.”
Interest rate increases could decrease LBOs, but present opportunities in distressed deals
Pulvino said there is a robust LBO calendar which will likely slow due to the cost of debt financing as interest rates continue to rise at historic levels across the globe. As rates go up, he expects to see an increase in convertible bond issues as companies needing cash will issue convertibles because they can offer lower coupon rates by allowing for a conversion option.
Pulvino added that there could be an increase in distressed situations, possibly presenting opportunities. He also predicted widening credit spreads would cause some restructuring to happen, which could present some investing opportunities.
Investors finding favor with Alternative Event Driven Funds
Investors have been putting money into the Alternative Event Driven Funds classification year to date. Through October 31, investors have parked $2.46 billion in cash in the classification, with $325 million of those net inflows coming in Q3. They have experienced inflows in seven out of 10 months this year, with the largest inflows coming in March ($490 million) and the largest outflows coming last month (-$140 million).
In general, it has been a positive flow environment for the Alternative Event Driven Funds classification over the past several years. In 2018, investors injected net inflows of $866 million; in 2019, Alternative Event Driven Funds drew $3.1 billion; in 2020, the classification drew $1.41 billion; and in 2021 investors poured $4.38 billion into Alternative Event Driven Funds.
Alternative Event Driven Funds last experienced outflows in 2017, when investors withdrew $194 million from the classification.
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