Morningstar Advisor - December/January 2010 - 45

they don’t work, such as stagflation. So, I don’t claim that government bonds are a panacea. The good news about them is that they make your portfolio more diversified and give you a higher risk-adjusted return. But they don’t make you a lot of money. What Andy and I are trying to do is create something that provides diversification but also adds a fair amount of return. We’re trying to generate things that, be they through market anomalies, liquidity premiums, or risk premiums, actually make you money. Government bonds are not a tremendous return enhancer. They’re a tremendous protector. We are trying to create strategies that in a crisis don’t become negatively correlated. That’s the beautiful thing. During crises, bonds move opposite of stocks. In a hedged, zero-correlation portfolio, you’re not necessarily going to make a ton of money in a crisis. It’s not insurance, like you might perceive bonds to be. But I think it will return considerably more over time. It’s about return with diversification, where bonds are really just about protection. AL: We’re trying to open up the investment scalable, and so on. At the opposite end of the spectrum is hedge funds, which are opaque, illiquid, have high fees, and not scalable. 11000 What’s missing right now is all of the potential products that are in between those two extremes. If you’re able to construct a 10000 bottom-up but relatively straightforward and simple version of a risk-arbitrage strategy that AQR has done, it provides tremendous benefits 9000 to investors who don’t want to be at either end of those spectrums, but prefer to be somewhere in the middle. Quant Approach to Risk Arbitrage CA: Andy mentioned risk arbitrage. It’s also Natixis ASG Global Alternatives Fund GAFAX $11K ML USD LIBOR 3 Mon CM 10 Oct 08 Oct 09 Category Long-Short Inception Sept 30, 2008 Minimum Investment $2,500 Data as of Oct. 31, 2009. Expense Ratio (%) 1.62 1-Yr Anl Total Rtn (%) 7.85 1-Yr Anl TR % Rank Cat 34 called merger arbitrage, and it is one part of what we do, but it’s an important part, and it’s a good example of a strategy that needs some tools—it needs to short, for example. Let me describe it for a second to give a feel for the strategy. When mergers are announced—by the way, if 11000 you do the strategy before mergers are announced, it’s the Ivan Boesky strategy, and it’s illegal, and you go to prison—in general, 10000 the target goes up. A premium is offered for it, but it doesn’t go all the way up to the merger price, because there’s still a chance the merger 9000 won’t go through. A lot of investors want out at that point. They say, “I’ve made most of my money, and why am I going to stick around for a little bit more and risk it all?” If you systematically buy those targets and hedge by shorting the acquiring firm, you’re betting that the merger goes through. You get paid a small amount if the merger goes through, as those prices converge. And, to be honest, if the merger doesn’t go through, you lose a lot more than you might have gained. Now, this sounds like a pretty bad deal, right? Because I just said that you make a little, but you can lose a lot. But how often matters. If you could lose 50% and make 5%, that’s 10 to 1. But if only one twentieth of the deals fail, that’s a pretty good strategy over the long term. If you pursue it with a lot of diversification, we Oct-08 Nov-08 Jan-09 Mar-09 May-09 Dec-08 Feb-09 Apr-09 Jul-09 Oct-09 Nov-09 Jun-09 Aug-09Fund AQR Diversified ArbitrageSep-09 ADANX $11K ML USD LIBOR 3 Mon CM 10 universe to a much broader set of factors, strategies, asset classes, and new ways of generating value for investors. Take traditional stocks and bonds, for example. If they’re long-only, you’ve got to realize that relaxing that restraint is important, particularly with markets that can go down. Changing that constraint from long-only to long-short allows you to change your beta from positive to negative with the flip of a switch. Obviously, it’s a very dangerous switch that you have to be very careful about, but that’s one example. Another example is to broaden the horizon from stocks and bonds to stocks, bonds, currencies, commodities, real estate, and private equity. There’s a whole spectrum of investments out there. I have a chart that represents the investment universe as a rainbow spectrum. One end depicts index funds, which are transparent, have low fees, are Feb 09 July 09 Nov 09 Category Long-Short Inception Jan. 15, 2009 Minimum Investment $5,000 Data as of Oct. 31, 2009. Expense Ratio (%) 1.75 6-Mo Total Rtn (%) 4.55 6-Mo TR % Rank Cat 61 Feb-09 Jul-09 Nov-09 Sep-09 think it’s aApr-09 strategy for investors. The great Jun-09 evidence for 30 years is that you get paid well Mar-09 May-09 Aug-09 Oct-09 to do this strategy. Many more deals close than don’t, and for the ones that don’t close, you get more than compensated by the many more that do. Its returns have relatively low correlation to markets, and it’s determined most often by specific deal situations. There’s MorningstarAdvisor.com 45
http://www.MorningstarAdvisor.com
Morningstar Advisor - December/January 2010

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2010
