The Arbitrage Series - Part 1

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur”  Warren Buffett

Arbitrage can be defined as 'the simultaneous or near simultaneous purchase and sale of the same securities or commodities in different markets to make a profit on the (often small) differences in price'.

This essay will take a brief look at 'classic arbitrage' and 'risk arbitrage'. Part two of the series will cover 'merger arbitrage', part three will cover 'time arbitrage' and part four will address 'spin-offs'

'Classic Arbitrage' refers to, for example, a trader noting a price differential between New York and London gold prices and then buying gold in the cheaper market to quickly on sell in the more expensive market to capture the 'spread' [ie profit] with almost no risk.  Gold prices in London were kept in line with New York, as arbitrageurs like this trader exploited any pricing anomalies.    

"A century ago, when you bought the same security in New York and London, there was just a little variation in price from one city to the other.  The professional bought the identical security in one city and sold it in another for a very small, but almost sure, profit." Roy Neuberger

With the advent of high speed communications and computer technology the opportunity for classic arbitrage no longer really exists. Today's example would be the high-frequency trader who arbitrages pricing discrepancies between the different stock exchanges in each market. The high frequency trader of today is a computer system which intercepts trade data at lightning speed and almost instantly sends market orders to other exchanges to arbitrage pricing differentials. In many cases these computers are trying to identify orders likely to be on-route to other exchanges [dirty poker?].  They co-locate computers at the exchanges [and pay premium rents to do so] to obtain quicker market data and low latency order routing, use microwave technology for communications, the latest computer chips for speed and employ complex algorithms. The rise of the machines has meant 'classic arbitrage' is impossible for mere humans.

The key idea in classic arbitrage is taking advantage of a pricing inefficiency with the absence of risk.  

'Risk arbitrage' takes advantage of a pricing inefficiency due to some form of trading imbalance or information uncertainty created by a corporate event.  These corporate events include mergers, tender offers, liquidations, spin-offs, stub trades and corporate re-organisations etc.    

The arbitrageur is trying to capture the spread between the trading price and the true value of the security.  This spread reflects both the time value of money until the event completes and a risk premium for the chance the deal won't complete, hence the moniker 'risk' arbitrage.  

Ultimately the arbitrageur is trying to identify mis-priced risk.  There are a lot of causes of this mis-pricing, for instance, it may result from a stock moving out of an equity index, lack of Wall Street coverage of a spin-off, the stigma of a bankruptcy reorganisation, excessive risk aversion due to the uncertainty regarding a deal's success, a cross border transaction involving securities outside existing shareholder mandates or the complexity/lack of understanding of the nuances of the event etc.  

"Since World War 1 the definition of arbitrage - or 'risk arbitrage', as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganisation, liquidation, self-tender etc" Warren Buffett

“Risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.” Seth Klarman

The advantage of 'risk arbitrage' is that these investments tend not to be correlated with the broader stock market as the event has a timetable for completion which is expected to close the pricing anomaly.   This helps protect the portfolio from market sell-offs.  These investments are often referred to as 'special situations' or 'event investing'.  

"The risk pertains not primarily to general market behaviour (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialise"  Warren Buffett 1963

“In the first place, with respect to a special situation as it is known in Wall Street.  That is a security which upon study is believed to have a probability of increasing in value for reasons not related to the movement in stock prices in general, but related to some development in the company’s affairs.  That would be particularly a matter such as recapitalization and reorganisation, merger and so forth.” Ben Graham

"The unique aspect of the strategy is its ability to earn attractive returns that are not dependent on the market's direction"  John Paulson

"Our goal is to make money independent of the direction of the market.. We always do this through arbitrage"  Brian Stark

"Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.”  Seth Klarman

Warren Buffett referred to these types of investments as 'work-outs' and employed the strategies at both the Buffett Partnership and then Berkshire Hathaway.

"Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire.  Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%" Warren Buffett 1988

Buffett recognised the benefits risk arbitrage positions would add to the overall portfolio.  In down markets, arbitrage positions tend to outperform. While they are likely to be a drag on performance in strong bull markets, it's outperformance in down markets which is the key to high long term returns.

"I continue to attempt to invest in situations at least partially insulated from the behaviour of the general market." Warren Buffett 1960

"This category produces more steady absolute profits from year to year than the generals [fundamental value investments] do.  In years of market decline, it piles up a big edge for us; during bull markets it is a drag on performance. On a long term basis, I expect to achieve the same sort of margin over the Dow attained by generals"  Warren Buffett 1963

While risk arbitrage returns tend to be uncorrelated with the market, in times of market stress, correlations usually rise. This occurs as mergers and tender offers are more likely to fail as acquirers re-assess the prices they are prepared to pay, or business conditions may mean material adverse change conditions are triggered, or market-out-clauses are triggered, or financing dries up or spin-offs trade poorly. Spreads can also widen as dedicated arbitrage funds may face redemptions.  

"The greatest risk in arbitrage is if capital leaves at the wrong time. You are attempting to exploit temporary mis-pricings between one security and another. Most of your success comes when the correct relationship between those securities is restored. When the relationship is out of whack and your capital leaves is when you get hurt" Brian Stark

As the arbitrageur is collecting the time value of money until deal completion, plus the risk premium for the risk of deal failure, the return can be computed as an annualised rate of return.  This return can then be compared to current interest rates.  When interest rates are low, annualised returns from risk arbitrage also tend to be low.  Some mutual funds use arbitrage as a proxy for cash when they are nervous about markets but mandated to remain fully invested.  Warren Buffett uses arbitrage as a proxy for cash, but only when returns are attractive. 

"Arbitrage positions are a substitute for short-term cash equivalents, and during the year we held relatively low levels of cash.  In the rest of the year we had a fairly good-sized cash position and even so chose not to engage in arbitrage.  The main reason was corporate transactions that made no economic sense to us; arbitraging such deals comes to close to playing the greater fool game.  (As Wall Streeter Ray DeVoe says:'Fools rush in where angels fear to trade)."  Warren Buffett 1989

Although risk arbitrage may be useful as a cash proxy, the danger is that when deals break, they look nothing like cash returns.   For example, in merger arbitrage and tender offers when a deal breaks, then losses can be 10-20x the expected return from the deal completion.  This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.   Many investors diversify and limit position sizes to help manage the downside risks.

"The gross profits in many 'work-outs' appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return"  Warren Buffett

Many specialist investors use leverage which enhances the annualised returns, but may significantly increase the risk profile.  While there is no optimal level of debt, an investor must consider the impact on the portfolio in stressed market conditions or when there are multiple deal breaks.  

"I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behaviour. My self imposed limit regarding borrowing is 25% of partnership net worth.  Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs"  Warren Buffett

"We believe that reasonably leveraged and well-hedge arbitrage portfolios are considerably less risky than unhedged, outright equity portfolios" Brian Stark

Successful risk arbitrage requires identifying the attractive potential investments where the probability of success is high.  

“We will engage in arbitrage from time to time – sometimes on a large scale – but only when we like the odds”  Warren Buffett

 "For every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced."  Warren Buffett

The strategy tends to be cyclical and like all forms of investing, this style will not guarantee success. At times when interest rates are low, there is an M&A boom or too much money chasing to few deals, returns maybe unattractive. 

"Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year, or for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: for every arbitrage opportunity we seized in the 63 year period, many more were foregone because they seemed properly priced. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better strategy than selecting a portfolio by throwing darts” Warren Buffett 1988

"We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: "If something can;t go on forever, it will end"  Warren Buffett 1988

Even the best arbitrageurs can have bad luck. The key is to ensure the portfolio can handle the downside should the worst case scenario happen.

"Our experience in workouts this year has been atrocious - during this period I have felt like the bird that inadvertently flew into the middle of a badminton game"  Warren Buffett 1969

Risk arbitrage can improve portfolio returns but it is not for the faint-hearted.  It's a highly specialised strategy requiring a broad array of skills.  Like all forms of investing you need to have an edge, work within your circle of competence and consider each investment in the context of the whole portfolio.  

"Corporations will forever be buying, selling and restructuring their way into better businesses, creating fodder for event-driven investors for years to come"  Jason Huemer

 

Further suggested reading ..

"The hedge fund manager's edge: an overview of event investing" Chapter 8 - Jason Huemer.  Evaluating and Implementing Hedge Fund Strategies" - Third Edition