After a brutal year, the convertible bond market has recently shown signs of life. But backbreaking losses at a handful of hedge funds demonstrate that trading these security hybrids is not for the faint of heart.

The latest example is Arbitex, a Dallas-based convertible fund run by Arbitex Asset Management. According to performance documents obtained by TheStreet.com, assets at the Arbitex Master Fund have plunged from $517 million in January to just $30 million at the end of August.

The 94% hammering shows what happens when a hedge fund fails to perform. Arbitex Master's investment return for the year to date is -13.2%. According to someone familiar with the situation, the rest of the shrinkage -- $420 million worth -- comes from investors pulling their money out.

An industry analyst says that the fund has not posted its September results yet. A call to Ken Tananbaum, Arbitex's founder, was not returned.

"He is a great guy, very smart," says a fund-of-funds executive of Tananbaum. "But the strategy got broken."

What hurt Arbitex is its so-called "volatility bias." As with most convertible arbitrage trades, volatility players buy convertible bonds and short the common stock of the companies issuing them. Unfortunately, Arbitex Master's strategy depended on fairly big price swings to make money. In this year's sideways market, the strategy was a loser.

According to Justin Dew, a Standard & Poor's hedge fund analyst, the S&P 500 is down 2.79% so far this year, while the CBOE Market Volatility Index, or VIX, has crept up just 5%, from 14.08 on Jan. 3 to 15.33 as of Tuesday.

"This fund is going to shut down before year-end," predicts one hedge fund analyst, citing, among other things, its managers' virtually nonexistent chances of ever collecting a fee from investors.

Arbitex is one example of a hedge fund strategy that has struggled. As of last week, the HFRX U.S. Convertible Arbitrage Index was down 6.18% for 2005.

Adrian Miller, a director in Citigroup's convertible research group, says higher stock prices have led convertible arbitrage to recover a bit since May. Still, most convertible shops continue to nurse wounds inflicted by a market that has witnessed what RealMoney contributor James Altucher calls a "death spiral."

Low volatility is one factor. A lack of new bond supply is another. Various corporate events, including Kirk Kerkorian buying a stake in General Motors ( GM), have complicated the short-sale hedging strategy.

Still, there is room for optimism for those who don't count on as much volatility, perhaps by employing other trading tactics.

"It is not a dead strategy by any means," says George Lucaci, managing director at Channel Capital, which operates the HedgeFund.net database. "There has been more interest in the credit game, as opposed to the volatility game."

Convertible traders in the credit space do take credit risk, unlike volatility arbitrageurs who hedge it. Credit players invest in junk-rated convertible bonds, also called "busted convertibles." Such securities are cheap and trade well below their conversion price, and are bought by managers who think they could rise as credit quality improves.

"We've seen a recovery in the convertible market, particularly in the credit-sensitive convertible market," says Dew. And that should give hope to market participants.

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