The right sorts of risks

Successful investment is based on well-reasoned analysis; excessive risk taking is inherently speculative and, in absence of factual analysis, guaranteed to eventually fail.

Indeed, without clearly favourable asymmetry and acceptable risks, diversification itself is pointless. The roulette wheel offers a useful lesson. The pay out on a single number is 35 to 1 but the odds of losing are 37 to 1 in the US (or 36 to 1 in Europe). Each additional bet is guaranteed to lose 1 or 2 and diversification cannot alter this. If a manager has no skill then the brokers and service providers are in effect the casino, earning their fees irrespective of performance.

Hedging and arbitrage as well defined investment strategies

PHILOSOPHY CHART[1]Arbitrage, hedging and special-situations are a specific case of securities analysis where intrinsic value can be more precisely calculated than the normal broad-brush range of estimates that is generally the case. This precision can be due to liquidation, merger, acquisition, and exchangeability into related securities, tender offers or simply securities trading at exceptionally low valuation. It allows for the application of a long/short position to isolate the valuation, sometimes combined with prudent leverage to enhance expected returns. In all cases, sufficient margin for error exists to allow for safety of capital.

We present the following hypothetical arbitrage trade example of a simple cash offer for the stock of a company to illustrate how fundamental risks interact with expected return. 1 By altering the entry price and probability of success, the expected return can be improved from 5% to 8%. However, a large range of possible outcomes remains and adding leverage can dramatically increase maximum possible loss (Chart). Yet, on an annualised basis and properly diversified, an arbitrage strategy could produce mid 20% or higher returns.

First rule of investing is not to lose money

Our objective is to provide investors with the information they need to make intelligent investment decisions by understanding investment logic and the potential downside. This is rarely captured in statistical inference, as observed frequency does not necessarily reflect actual probability. All things being equal, greater risks should reduce the amount invested in a particular hedge fund in favour of a fund with lower risks. Excessive risks with the possibility of large capital losses are speculative and should not be attempted. We seek to recognise when excessive risks transform investment into speculation.

Hamlin Lovell, CFA & Keith Tomlinson, CFA

  1. We use Graham and Dodd’s arbitrage formula to illustrate hypothetical returns from the following arbitrage trade example: “Original trade” is £50/share pre-takeover; £70/share offer; and £65 current share price with 90% probability of deal completion. “£2 more upside” assumes £63/share current price. “9% higher probability” assumes 99% probability of deal completion. “Apply 0.6x leverage” magnifies the potential gains and losses accordingly. We assume no transaction costs and a simple one period return.

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