Convertible returns for 2004 seen in 10% area; hedge funds expect gains in volatility boost

By Ronda Fears

Nashville, Jan. 1 - Convertible returns in 2004 are likely to trail 2003's whoppers, at least from an outright position, but industry participants expect on average gains to be in the neighborhood of 10%, give or take a couple of percentage points.

For those involved in a high delta strategy, the gains could be larger at 15% to 25% if the bullish trend continues in the stock market.

Income-oriented funds, however, will probably have to shift from the more speculative credits to more solid ones in order to preserve returns, even though interest rates are likely to be on the rise. As junk bonds led spread compression, many think they also will lead the widening when it comes to pass.

Hedge funds, which didn't have as good a year in 2003 as the outrights, are anticipating the volatility play will be where most of the action is in 2004, since they are netting out the options on the underlying stocks and credit spreads are apt to be widening from 2003's historic lows.

In general, outright convertible funds averaged gains in the area of 20% to 25% in 2003, according to research teams of the major investment firms like Citigroup Global Markets Inc. and Merrill Lynch & Co. Inc. That was a turnaround from negative posts, in the 5% to 10% neighborhood, for 2002.

"2003 was the recovery year, so 2004 probably won't be as good, probably in the low double-digits or high single-digits," said Tom Dinsmore, president of Davis-Dinsmore Management Co.

Showing quite the opposite trend, the convertible arbitrage strategy essentially flip-flopped with outright dedicated convertible players in 2003.

Through the end of November, CSFB/Tremont shows the convert arb strategy with a year-to-date gain of 12.11% and Merrill Lynch puts the year-to-date rise at 15% though the middle of December. While decent, those gains compare to something in the neighborhood of 20% to 30% in 2002.

Hedge funds, though, have an increasing array of products to use to insulate their investments, such as the new volatility arbitrage strategy that is gaining popularity.

Indeed, under the current dynamics in the market, hedge funds are looking for volatility to be the area with the most opportunity.

"If you net out the returns related to the stock options, the other sources of return are volatility and credit valuations," said Simini Farcasiu, chief portfolio strategist at Silverback Asset Management, a large hedge fund based in New York.

"We don't anticipate outsized returns from credit spreads. Credit spreads are very tight right now. There's reasonably low volatility, though, so that's were it will come from.

"As volatility picks up, though, spreads could widen as a result, and that will tend to limit returns."

Farcasiu is not overly concerned, however, noting that "the market is increasingly liquid and efficient, we are using more instruments to hedge."

Dinsmore said he believes the two key points driving continued gains in 2004 will be U.S. gross domestic product growth of about 4% and the so-called peace dividend, which could conceivably add another 1% to 2% to GDP. He agrees with the former, but is somewhat skeptical about the latter.

"We have come to the conclusion that we are going to get about 4% GDP growth. That's key. So pretty much all the equities should benefit," Dinsmore said.

"That said, a lot of that is already in the market. I don't think it's going to be a gangbuster year like some people are thinking. When you've had such a downturn, people remember that.

"It's not like 1999 when people were just throwing money at the market. It would surprise me to see the psychology go back to that of the late 1990s."

No longer is it the rule of thumb that it's smart to sell into market rises and buy into the dips, he said.

If there was another 20% to 30% gain in the market, Dinsmore said that would be a warning signal that it was in for a serious correction.

As for world peace, he's skeptical, but believes the terrorism threat can be "made manageable." But, he conceded: "If there's a peace dividend - peace breaks out and terrorists disappear - then all bets are off" in regard to his expectations for the market.

A slightly higher level of returns are anticipated by Richard Russell, portfolio manager for the ACM Convertible Fund, which is ending 2003 with a return of about 43.5%, making it the top ranking convertible fund tracked by Morningstar Inc. And, as wild as that sounds, the fund was up by around 50% earlier this year.

Russell expects that, conservatively, his fund could see something between the 12% to 15% expected for the S&P 500 and the 20% to 25% expected for the Nasdaq. His strategy is very high delta oriented, which positions it to gain the most from gains in the underlying stocks.

"We've ended the phase of the bull market where everything got marked up," Russell said.

"In the last couple of months there's been a correction where growth stocks backed off and cyclicals picked up."

Still, Russell foresees the technology group, semiconductors, software and the like, as a source of strong growth in 2004, perhaps largely from potential consolidation in those areas by way of takeovers.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.