What it means
Imagine two government bonds that are almost identical, but one trades at a slightly lower price because it is less popular with investors. A relative value fund buys the cheaper bond, sells the dearer one, and waits for their prices to move back together.
If the whole bond market rises or falls, the gains and losses on the two positions largely cancel out, and the fund keeps the profit from the gap closing. The strategy covers many specific trades.
Fixed income arbitrage focuses on bonds and interest rate instruments, convertible arbitrage pairs a convertible bond with the underlying shares, and capital structure arbitrage compares a company's debt and equity. Each is a different way of exploiting prices that have drifted away from where they logically should be.
Because the price gaps are usually tiny, often a fraction of a percentage point, these funds typically use a lot of borrowed money to turn small differences into worthwhile returns. That leverage (borrowing to increase the size of a position) is the source of both their appeal and their danger.
A trade with a small expected profit and a very large position can lose heavily if the gap widens before it narrows. Investors, including pension funds and endowments, hold relative value funds as a diversifier, because their returns should be less tied to equity markets.
In calm periods, the funds can deliver smooth, modest gains, which is why they are often described as picking up pennies. The risk is that the pennies are collected steadily and then lost in a hurry.
The nuance is that relative value is not risk-free arbitrage. Trades can stay out of line for longer than the fund can afford to wait, especially when markets are stressed and lenders ask for more collateral, forcing the fund to close positions at a loss.
Understanding the leverage, liquidity and the fund's ability to survive a bad stretch matters more than the headline return.
In practice
Real-world examples.
Example
A hedge fund notices that a ten-year government bond trades at a slightly higher yield than a nearly identical bond with a different maturity date. It buys the high-yield bond and sells the other, and earns a profit when the yields converge. The profit is small per dollar but large relative to the capital used.
Example
A fund buys a company's convertible bond and sells short a number of its shares to offset the share price risk. Over the next months the shares become more volatile, which raises the value of the conversion feature. The fund gains from the bond's value increasing while the short position protects against a share price fall.
Example
A pension fund allocates 5% of its portfolio to a relative value fund to diversify away from equities. In a year when shares fall 10%, the fund returns a small positive amount. The trustees note that the strategy delivered what it promised, steady returns with a low link to the stock market.
Formula
Calculation
Approximate profit = Position size x Duration x Spread tightening
Suppose a fund buys $20,000,000 of a cheaper bond and sells short $20,000,000 of a similar, more expensive bond. Both have a duration (a measure of price sensitivity to yields) of 5 years, and the yield spread between them narrows from 0.40 to 0.10 percentage points, a tightening of 0.30 points, or 0.0030. Profit = 20,000,000 x 5 x 0.0030 = $300,000. If the fund committed $4,000,000 of its own capital to the position, the return on that capital is 300,000 / 4,000,000 = 7.5%, before financing costs and fees.Case study
Seen in the real world.
Kestrel Relative Value Partners is an illustrative, fictional hedge fund running $500,000,000 in fixed income spread trades. For several years it earned steady returns of around 6% a year by exploiting small price differences between related bonds, using borrowed money to multiply each position five times.
During a sudden period of market stress, investors rushed towards the safest bonds, and the price gaps in the fund's trades widened instead of narrowing. Lenders asked for extra collateral, and the fund had to sell some positions at a loss to raise cash.
The losses were painful, even though the original trades were logical and would probably have recovered given more time. The illustrative lesson was that relative value funds can be right about prices and still fail, because borrowed money limits how long they can wait.
Watch out
Common mistakes.
- Believing that relative value funds are risk-free because they buy and sell similar assets at the same time.
- Looking only at average returns and ignoring how much leverage was used to produce them.
- Assuming returns are unrelated to markets in all conditions, when many relative value funds suffer losses during financial stress.
Questions
People also ask.
How do relative value funds make money?
They profit when the price difference between two related investments narrows, by owning the cheaper one and being short the more expensive one.
Why do they use so much leverage?
The price gaps are small, so managers borrow to increase position size, which multiplies profits and losses alike.
Are relative value funds the same as arbitrage funds?
They are related, but true arbitrage is risk-free while relative value trades carry the risk that the gap widens or never closes.
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