Fund manager Mikhail Filimonov isn't taking any chances, or any large ones anyway, with investments like that of his nine-year-old daughter's college savings. Instead, Filimonov has adopted a low-risk, high-reward approach for his Alexandra Global Investment Fund, so-named for his daughter. Buying convertible bonds and simultaneously selling short the underlying stock, Filimonov positions his investments to be neutrally hedged - in other words, immune to market fluctuations. If a stock price falls, the investment is protected -- and often enhanced -- by the short position. No matter the stock price, the investment generates profits from interest on the bond and short sale proceeds.

        Filimonov's approach is called convertible bond arbitrage, one of many "hedging" strategies found in the hedge fund universe. Hedge funds refer to funds that can use one or more alternative investment strategies. Popularly perceived to be risky due to over-publicized losses in global macro funds in recent years, hedge funds, in fact, by their very definition seek to protect their investments by hedging against the downside. True, not all hedge funds "hedge," but many do, and one of the most successful of these techniques is convertible bond arbitrage.

        The term arbitrage refers to the trading strategy of identifying assets which are not efficiently priced by the market in comparison to prices of other related assets. In the case of convertible bonds, it works like this: Take a 5% convertible bond maturing in one year at $1,000, exchangeable into 100 shares of non-dividend-paying common stock currently trading at $10 per share. An arbitrage strategy might hedge against this long convertible bond with a short position of 50 shares of underlying common stock at $10 per share. Pricing inefficiencies between these two related securities, as we'll see, allow for profits both when the stock price rises and falls. Adding to gains on the downside is the fact that convertible bonds can only fall in value as low as their "investment value" -- the value of the same company bond if were it were not convertible. In this case, let's say the investment value is $920.

        An investment position such as this would likely have the following return dynamics:

Return When No Change in Stock Price:

Interest payments on $1,000 convertible bond (5%) Interest earned on $500 short sale proceeds (5%) Fees paid to lender of common stock (0.25% per annum) Net cash flow Annual Return

$50 $25 ($1.50) $73.50 7.3%

Return When 25% Rise in Stock Price:

Gain on convertible bond Loss on shorted stock (50 shares @ $2.50/share) Interest from convertible bond Interest earned on short sale proceeds Fees paid to lender of common stock Net trading gains and cash flow Annual Return

$250 ($125) $50 $25 ($1.50) $198.50 19.85%

Return When 25% Fall in Stock Price:

Loss on convertible bond (only falling as low as "investment value") Gain on shorted stock (50 shares @ $2.50/share) Interest from convertible bond Interest earned on short sale proceeds Fees paid to lender of common stock Net cash flow Annual Return

($80) $125 $50 $25 ($1.50) $118.50 11.85%

        As this example shows, if a convertible bond arbitrage position is properly constructed, it should profit not only from the bond coupons and short rebate but from changes up or down in the underlying equity price. In other words, if the stock price drops, the gain from the short common stock position should exceed the corresponding loss on the long convertible bond. Likewise, if the stock price rises, the gain on the long convertible position should be greater than the accompanying loss on the short common stock position.

        Explains Filimonov of his fund's position in Gold Mines of Kalgoorlie (Australia), "The position generates cash flow (bond coupons less stock dividend, less financing cost, plus short rebate) of 12% per year. On top of that, hedged neutrally against stock fluctuations, the position makes an additional 2% for every 10% up or down in the underlying stock."

        Adding substantially to the upside, of course, can be leverage. Given the low-risk nature of convertible bond arbitrage, leverage is often an attractive option to investors.

        If convertible bond arbitrage sounds simple, well it is. But simple doesn't mean easy: In fact, fund managers caution against small investors trying it on their own. Reasons: Timing. If you're 30 seconds too slow in executing a trade, gains could quickly turn to losses. Furthermore, high brokers' fees and brokers not paying interest earned on the proceeds of short sales can also cut into profits.

        In the five years from 1992 through 1996, market neutral arbitrage funds, of which convertible bond arbitrage is a part, netted 13.5% per year compounded. Those are impressive numbers to anyone, not only investors whose first priority is to preserve capital. Though when it's a loved one's future at stake, like young Alexandra Filimonov, protecting capital while reaping strong returns is especially sweet.

Learn More About Hedge Funds

  What Is a Hedge Fund?
  What Are the Different Hedge Fund Strategies?
  Hedge Fund Styles
  Advantages of Hedge Funds Over Mutual Funds
  Benefits of Hedge Funds
  What Is a Fund of Hedge Funds?
  Benefits of a Fund of Hedge Funds
  Hedge Fund Articles

  Taking the Mystery Out of Hedge Funds
  By Dion Friedland, Chairman, Magnum Funds

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       Market Neutral Long/Short Equity Trading