Arbitrage and long-short equity: Pivoting in a rising-rate world

CEO and chief investment officer highlights growing appeal of alternative strategies

Arbitrage and long-short equity: Pivoting in a rising-rate world

Changing interest rate regimes have always played a significant role in investment strategy, given their influence on market sentiment and investor behavior. The allure of zero interest rates of the past 15 years primed the boom in sectors like real estate, technology stocks, venture capital, and private credit. 

Now, however, the ascending trajectory of benchmark rates is putting these once-thriving strategies under the microscope.

According to Julian Klymochko, CEO and chief investment officer of Accelerate Financial Technologies, as these traditional sectors face challenges, the investment community is increasingly turning to some highly innovative alternative strategies that present fresh avenues for potential growth and risk mitigation.

“The environment has changed dramatically versus two years ago,” Klymochko says. “Those strategies struggle substantially, whether it's speculative tech stocks, venture capital, real estate or private credit. It's a tough space these days.”

In the current reality, Klymochko is turning his attention to a pair of strategies which he says thrive in a rising-rate environment, offering both stability and opportunity for investors. One is arbitrage, the practice of capitalizing on price discrepancies in different markets to lock in risk-free profits.

The second is long-short equity and market-neutral strategies, which are designed to exploit stock mispricings while minimizing exposure to broader market movements.

Klymochco says long-short equity and market-neutral strategies, which involve investing in chosen stocks (longs) while short-selling others, were disadvantaged in a zero-interest rate era. "When you short those stocks, you generate a pile of cash, and you invest that cash. When interest rates were zero, you didn’t make money on that cash. It just sat there,” Klymochco says. Now “on that pool of cash we get from short selling, we're earning north of 5%." As the cost to borrow remains stable at around 0.8%, these strategies stand to generate returns above 4% from the short positions alone, he says.

Accelerate, a Calgary-based alternative investment provider, offers diverse funds like hedge fund ETFs and crypto ETFs, and has pioneered initiatives such as the first 0% management fee alternative ETFs and a long-short equity hedge fund within an ETF wrapper.

Klymochco says that in the current high-interest rate environment, arbitrage strategies are also extremely well positioned.

Arbitrage is a financial strategy that capitalizes on price discrepancies of identical or similar assets across different markets or forms. Traders who employ this tactic buy the undervalued asset and simultaneously sell the overvalued one, locking in a risk-free profit as the prices converge. This strategy, often executed with the aid of sophisticated technology and algorithms, ensures market efficiency and equal asset pricing across various platforms and regions.

Arbitrage actually represents a very broad set of strategies and can mean many things to many investors. Klymochko’s focus centres on SPAC and merger arbitrage, the specialized technique of capitalizing on price discrepancies between the shares of companies involved in a merger or acquisition.

As SPACs, or special purpose acquisition companies, have gained traction in recent years, they present unique opportunities for those savvy in arbitrage strategies. A SPAC, also known as a "blank check company," is a shell entity established to raise funds through an IPO explicitly for acquiring a private company. By doing so, the private company becomes publicly traded, bypassing the traditional IPO process.

“Those strategies kind of fell out of favour when interest rates were zero, because they were much more difficult to generate good returns,” Klymochko says.

Typically, if a SPAC doesn't identify a suitable acquisition within about two years, it's liquidated, and the raised funds are returned to the investors.

Parallel to this, merger arbitrage is an investment strategy used to exploit the price discrepancies of stocks in merging companies. When a merger is announced, it's common for the acquired company's stock price to rise, but not to the full proposed acquisition value due to the inherent risk of the merger not finalizing. Investors can capitalize on this gap, purchasing stocks at the lower price and profiting if the merger completes at the expected higher value.

The returns from arbitrage strategies are closely tied to the Federal Reserve's funds rate. When the Fed funds rate rises, the returns from arbitrage strategies adjust quickly in response. In simpler terms, as the central bank's interest rates go up, the profitability of certain arbitrage strategies can change rapidly.

“If we rewind two years, a low-risk merger arbitrage trade would have yielded 3% and a high-risk merger arbitrage trade maybe 5% or higher. [Now] a low-risk merger arbitrage trade is yielding 7-8%. In a high-risk merger arbitrage, trading yields north of 10%. It even compares quite favorably to high-yield bonds.”

The democratization of arbitrage, which was once the playing field for exclusive family offices and stalwarts like Warren Buffett, has some distinct driving factors.

Due to regulatory changes, specifically the new liquid alternatives regime, firms were enabled to provide arbitrage strategies like those in institutional portfolios, making them available through ETFs and mutual funds. This made these strategies more accessible, cost-effective, and transparent for individual investors and investment advisors alike. The rise in technology and educational efforts around these strategies also played a significant role, Klymochko says.

"Ultimately, the rubber hit the road after 2022. Everyone was suffering big losses and thought there's got to be a better way. So, they finally started paying attention to these alternative strategies that can really help portfolios."