Bottom-Fishing in an Underwater Market

Bill Ellsworth takes on convertible arbitrage with Admiral Capital.
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As bear markets age, contrarians start to test the waters. That explains Admiral Capital Management, a new hedge fund that is diving into convertible bond arbitrage after a brutal two-year swoon in that market.

Although undertaken by a high-profile trader, the timing of the launch could raise eyebrows. Far from a breeding ground of new opportunity, the convertible bond market in recent months has seen numerous funds losing money, returning money to shareholders, or simply shutting their doors.

Bill Ellsworth, former head of convertible arbitrage at

Morgan Stanley

and the founder of Admiral, believes those problems make the time ripe for a start-up. "The deterioration you've seen in the past 18 months has created value," he says.

Ellsworth is a veteran trader known in the industry and has more than just money to lose in his new venture. Prior to his role at Morgan Stanley, his tenure included 10 years as head of convertible trading at Smith Barney, CIBC and

Wachovia

(WB) - Get Report

, according to his marketing material. "I almost started a hedge fund two years ago, but back then, the market was overvalued," he says. "It was bad timing."

Ellsworth's departure from Morgan Stanley last June coincided with a major management shake-up at the firm. His boss, Guru Ramakrishnan, along with Vikram Pundit, two high-profile traders, revolted against chief executive Philip Purcell, and their departure precipitated the CEO's ousting. Ramakrishnan and Pundit founded Old Lane Management. Now Ellsworth is following suit with his own hedge fund.

The bear market in convertible arbitrage began in 2004 and lasted through last year, Ellsworth notes. During the downturn, most bonds were overpriced, too many players chased the same deals, and volatility -- which hedge funds rely on for profits -- was nonexistent.

"All funds of funds pulled out in the last six to nine months," Ellsworth says. "They bought high and sold low. When things get washed out, there is an opportunity to get in."

Knowing first-hand how difficult the market was, Kevin Crouchley joined Admiral as a partner after winding down his own convertible shop Alta Partners, a hedge fund that once boasted $1.5 billion in assets.

Ellsworth estimates that 50%-60% of the money in convertible fund hedge funds was redeemed over the past two years, while about 20 funds shut down.

"We've hit the bottom," he says. Market losses culminated last spring, when the strategy returned a negative 3% in April alone. From January to May of last year, convertible arbitrage returned a negative 7%, according to CSFB/Tremont.

Things began to turn around after June. Between then and now, annualized performance has gravitated to around 10%, Ellsworth points out. For January alone, returns should be close to 2%.

When shops closed down, they were forced to sell in panic mode, depressing the price of convertible bonds on the secondary market. Survivors won.

Convertible traders typically own convertible bonds and hedge the price risk by shorting the underlying equity. As buyers, they benefit from cheaper bond prices.

One of the clearest signs of recovery is the recent pickup in volatility driven by inflation scares and higher energy prices. Since December, the CBOE Volatility Index, or the "fear" index, moved from the low 10s to 14.5 in mid-January.

Volatility is particularly important for the performance of convertible strategies. Managers generally make money when stock prices move up or down, regardless of the direction of the move.

The worst-case scenario is when volatility goes nowhere, says Ellsworth, and this is pretty much what happened during this bear market. In such cases, managers lose money.

That said, it remains to be seen whether the timing of Admiral's launch works out. Many still believe that the market sentiment will remain bearish for a while.

"The market has gotten a little bit better over the past two months, but it's still not compelling. Valuations are not that cheap. You have to move into small-cap, where it's not liquid," says James White, who runs Excelsior Capital Management, a fund that posted positive returns last year. "If you have a lot of money to move into this space, it's going to be hard."

For now, moving money is not Admiral's chief ambition. The fund is only targeting $200 million to $300 million in assets. For a manager with this pedigree, in talks with Morgan Stanley and

Goldman Sachs

for his prime brokerage business, the estimated sum is modest.

"I want to be realistic because we are not in the bull market, yet," says Ellsworth.

For now, the fund will appeal mostly to funds of funds, a class of investors often categorized as "hot money" rather than to the so-called "sticky money" -- the more conservative pensions and endowments. "This tumultuous convertible space has been going through a lackluster performance, and allocators are not too anxious to put money into the space," says Crouchley.

One way convertible shops have protected themselves against wild market swings has been to expand from their convertible roots into a multistrategy formula. For some, the "death" of convertible arbitrage is reflected in the fact that fewer players have remained solely focused on the strategy. Admiral won't be an exception. It plans to add other strategies that gravitate around convertible arbitrage within two or three years, including fixed-income arbitrage and event-driven strategies. Just in case.