Introduction

The Savin Multi-Strategy Arbitrage Fund specializes in relative value trading strategies, or commonly referred to as arbitrage strategies. A strategy where we identify and exploit mispricing of one instrument compared to a closely related instrument’s pricing, using long and short positions. The type of instruments we trade include equities, bonds and derivatives such as options and warrants.

Arbitrage strategies are active trading strategies. The mispricings we aim to capitalize on are often a result of volatile markets and or fleeting liquidity resulting in market inefficiencies and dislocations. The trading strategy does not involve making bets on the direction of markets or individual shares. That’s why the strategies are called market neutral. Every position in all our arbitrage strategies is hedged, meaning long positions in a security are ‘countered’ by a short position in the same or closely related security. The so-called spread or price difference between the two securities is where we aim to make our money.

Multiple ‘sub-strategies’ fall within the relative value strategy. At Savin we aim for positive uncorrelated returns by blending equity arbitrage, credit arbitrage, volatility arbitrage and structured products arbitrage. Quantitative and systematic trading strategies that are designed, implemented and executed by our portfolio managers Iain Somers and Ricardo Westra and their trading team.

Different strategies with different return profiles, but they should all be able to benefit from volatility and able to perform in rangebound markets. We generate our returns from capitalizing on market inefficiencies and dislocations mostly caused by volatility.

The nature of our relative value strategies allows the fund to be an investment uncorrelated with traditional investments such as equities and bonds. In a time where diversification through conventional assets is becoming increasingly difficult (as many are more correlated than they appear), this is where an investment in these strategies can add value to your investment portfolio.

This paper will provide a deeper dive into our strategies and an explanation of the return drivers of each strategy, and how they complement each other.

 

Volatility Strategies

Volatility strategies make use of derivatives (options, warrants, futures). Volatility is interesting because it is one of the main pricing components of options and warrants. Warrants and options are quite similar, the main difference is that warrants are issued by the company itself and options are issued by the exchange. When buying an option or a warrant you buy the right to purchase or sell shares for an agreed price at an agreed moment in the future. The price is determined by the length of the agreement, the agreed price, current interest rates, but mostly by the volatility.

Where volatility determines the chance the underlying price reaches a certain level and potentially increases the value of the option. So when volatility goes up the price of options go up and vice versa. When market makers set the price for an option they also price the volatility (the implied volatility). When the expected volatility of a share goes up, the market maker (the seller of the option) wants to be compensated for the risk it takes selling the option. So the price of an option goes up. Typically you see options getting more expensive towards the moment of earning release of a company for example. Earnings announcements have the potential for a strong share price movement, for which the seller of the option wants to be compensated. The volatility the market uses for the pricing of its derivatives is called implied volatility.

In this volatility strategy, we would like to find equities that are “cheaply” priced in terms of volatility. We aim for a basket of around 30 names versus the index. For our US strategy we hedge with the S&P index and for our European strategy we hedge with the Eurostoxx50. For both books we remain a long volatility bias (net Vega long), meaning that we tend to profit from rising market volatility and equity spikes on the selected names.

In order to find these equities we have built in-house proprietary volatility pricing and screening models. These quantitative models run on various parameters and give a score as an output per equity. Each equity gets a grade from 0 to 10, where 0 indicates that the implied volatility in the equity is relatively “expensive”, and a 10 indicates that the implied volatility in the equity is relatively “cheap”.

In order to compute this total score per equity, we use a variety of quantitative inputs and weights. Three of them we describe in more detail below.

1. Realized vs implied: For every stock in our universe we compute a realized volatility of the past. Computing the realized volatility of a stock is not straightforward, e.g. how do we deal with large moves caused by specific news such as earnings, does one take the close-to-close moves or also take intraday moves into consideration? After this computation, we compare this realized volatility to the implied volatility priced in the options. During this comparison, we put more weight on the more recent realized volatility than the realized volatility that happened a long time ago.
2. Downside: This score indicates how much risk there is when we would set up a long volatility position in the specific equity. In the computation of this subscore we look at two things. On one side we look at a measure for the maximum Vega-loss by taking into account past implied volatility and comparing that to the current implied volatility. On the other side, we look at a maximum Gamma/Theta-loss by looking at the period with the lowest realized volatilities of the recent past compared to the current implied volatilities.
3. Upside: This score indicates how much potential there is when we would set up a long position in the specific equity. Just like the downside score it is build up out of two things. First by comparing the current implied volatilities with a measure that looks at the period in the recent past with the highest implied volatilities, excluding spikes.

Second, by comparing a measure that looks at the highest realized volatility over a multi-day period in the recent past with the current implied.

These are three of the sub-scores that drive our total score. Besides these three, we have other quantitative and more fundamental parameters that we take into consideration.

On the fundamental side we look at factors as macroeconomic and sector-related news, companyrelated events such as earnings and (potential) M&A activity. We also avoid having a concentration of our long positions in the same sectors. From all the total scores, we look into the best scores, where we by hand select the best opportunities. Our selection and selection criteria are continuously back-tested versus a random basket of individual names to confirm we have an edge in selecting our stocks.

In terms of implementation, for this strategy we need to maintain our risk exposures daily. This is an active trading strategy where we systemically delta hedge our positions and adjust our portfolio.

For example we can trade the 3 month at the money straddles, delta hedge every day and adjust our portfolio on every 5-10% move on a component to keep our “Vega” exposure. Changes in “Vega” or “Gamma” exposure are managed by trading individual single stock options.

Even though this strategy is not a full dispersion strategy, we still profit from increased dispersion of stock returns. We are looking for really important moves on single names compared to the movement of the index.

 

Stock returns: High Correlation                                                 Stock returns: High Dispersion

Dispersion trading is not far from long/short equity trading. Instead of trading the valuation of a stock versus another one, we are trading the valuation of the volatility of our bespoke selection compared to the volatility of the index.

This strategy performs well when there are isolated large moves in the single stock names, for example profit warnings, and when overall levels of volatility are rising.

This strategy performs less well in times when there is less movement in the markets than implied in the option prices, because we pay more “Theta” on our long stock vol positions than we receive on the short index vol position.

Warrant arbitrage is a volatility strategy, where we capitalize on the mispricing of the implied volatility of warrants issued by the company and options listed on the exchange. In theory, a warrant issued by the company with a certain strike and expiration should be priced the same as an option listed on the exchange with the same specs. If the warrant is trading cheaper than a comparable call option, this difference can be explained by a different pricing of volatility, i.e. the expected movement of the underlying shares. We can profit from this difference by buying the warrant and selling a call option or even the shares themselves.

The reason for the price difference can be found in the fact the warrants and options are priced by different market participants, the popularity of one product (options) over the other (warrants), liquidity and often customized specifications of warrants making them harder to price. Our edge is in valuing these warrants. An in-house developed warrant pricing model enables us to spot opportunities and capitalize on these mispricings.

 

Equity Arbitrage

Our equity arbitrage strategies focus on the equity side of a business. Here we look at share class arbitrage, holding company arbitrage and structured products arbitrage. Our credit arbitrage strategies capitalize on mispricings in the credit spread of corporate bonds relative to the value of the equity of a business.

The most straightforward arbitrages are found in our share class strategy. Our share class arbitrages aim to capitalize on the moving spread or price difference between voting and non-voting shares. A true arbitrage where two share classes with identical cash flow from the same company trade at different prices.

Companies issue multiple shares classes for a variety of reasons. Both share classes give the right to the same amount of profits/dividends but differ e.g. only in voting rights. The market often assigns a discount to the non-voting shares. Because of the lack in voting power, but also because non-voting shares are often less liquid. So what should the discount be between those two share classes? This is determined by market forces and differs over time but often trades around a long-term average. If and when enough data is available one can often determine a long-term average. When the price difference moves away from this long-term average we set up a position anticipating a return to its long-term average, a reversal to the mean as it is called. In volatile markets, where we tend to see supply and demand imbalances in the underlying shares we often see the spread between share classes widening. This is when we aim to set up positions.

This strategy doesn’t profit from volatility directly. Existing arbitrage positions in this strategy might get hurt by the widening of spreads, if we enter a period of high volatility. On the other hand, the opportunity set to set up new positions on wider spreads increases, and thus the profit potential increases.

Our share class arbitrage strategy is a systemic mid-frequency trading strategy, where trading steps and sizes are pre-defined. Return profile and profit potential is very much dependent on the volatility of the price difference and the time it takes before the spreads return toward their long-term averages. Basically, a strategy you want to keep monitoring and have your eye on for if spreads widen and get interesting. Mostly the case in downward spiking and volatile markets.

Our other equity arbitrage strategy involves holding company arbitrages or so-called stub trading. Holding companies often trade with a discount relative to their sum of the parts. The logic goes that if you can value the individual (listed or non-listed) parts of the business you can put a value on the holding company.

As a simple example, suppose the listed holdings of a holding company are valued at $9 in a $10 stock, the market is essentially saying that the rest of the business (core business, non-listed holdings) is valued at $1. In this case, you say the stub is trading at 1 (this can easily be a negative number and often is). An alternative way of looking at this is to take your estimated value of the remaining businesses and add them to the value of the holdings (9 in this example) and come up with a total net asset value (NAV). If we say the businesses are valued at 6 then the total value equals 15 (9+6) and the company is trading at a 33 percent discount to its NAV (5/15). This is what is meant by a holding company discount. If we believe the stub is trading too cheap, we would be able to create a trade where we would go long the holding company and hedge its holdings proportional to their value.

Our structured products arbitrage mostly revolves around SPACs. A SPAC is a shell company that raises capital in an initial public offering (“IPO”) and uses this capital to acquire a privately held company not yet identified at the time of the IPO. The time spent searching for an acquisition target is limited to a predetermined time frame.

The opportunities we look for are SPACs that trade at a discount to their NAV, to achieve a yield greater than the one from US government bonds. SPACs often show a discount to NAV because they are less liquid than government bonds, which offer the same yield. Investors seek to be compensated with a higher yield in return for owning the less liquid asset.

When a SPAC announces an acquisition target, the market’s reaction to the potential merger will be considered. If a favorable deal is announced where the SPAC share price exceeds its NAV, the shares will be sold immediately, and the (free) appreciation optionality is locked in. If the deal is not considered attractive and the shares do not trade above the NAV, we will be able to return the SPAC shares and receive the NAV plus interest and close the position. If the SPAC does not announce an acquisition target before the agreed deadline or if too many investors vote against the acquisition in the event of an unattractive merger, the SPAC will be liquidated and we will also receive the NAV plus interest.

Apart from potentially limited liquidity, arbitrage investments in SPACs carry little downside risk. SPAC arbitrage may be viewed as an option to potentially benefit from a successful merger of the SPAC with a company for which there is nothing to pay, but with which to the contrary a return can still be generated.

 

Credit Arbitrage

Our credit arbitrage strategy focuses on the debt and equity part of the business. In this strategy, we aim to take advantage of the mispricing of a company’s equity- and debt-linked securities.

Theoretically a firm’s debt, equity and option prices should fall into a predictable, model-based relation known as the “contingent-claim view” of the firm. Not surprisingly, market values do not always equal theoretical or fundamental values.

Using in-house developed quantitative models and fundamental analysis, we analyze these relations and enter into market-neutral positions that should profit as market value moves toward fundamental value.

A combination of high credit spreads and relatively low implied volatility of the underlying security gives us the opportunity to take a position so that the expected return at the bond’s expiration is positive. Our sole exposure in the bond will be to the credit spread, therefore the interest rate is hedged dynamically. The highest return can be expected when a company’s stock falls significantly, while the value of the bond is less affected, allowing us to profit from both the bond as well as our equity hedge. This gives us natural tail protection with the upside hedged by the bond. We spot opportunities by monitoring over 100 companies with bonds maturating within the next one to three years. Credit spreads and option prices are screened daily to spot mispricing. We aim to have a maximum of 25 positions in our credit arbitrage book to maintain close monitoring of our positions.

Downside Risk Mitigation – Tail Risk Hedges

These hedges are designed to pay out in extreme distressed markets, as we have seen in March 2020, and are an integral part of the risk management of the fund. We invest in derivatives with an asymmetric return profile because they profit from fast falling markets and spiking volatility, convex because returns become exponentially bigger the harder the market falls. Designed to protect the overall portfolio in very distressed markets but also to be able to capitalize on the market dislocations and inefficiencies arising from such a move.

For more information on tail risk hedging, please visit savinfunds.com for an earlier article “Why we hedge our tail” on tail risk hedging.

Glossary

Arbitrage: is the purchase and sale of different instruments with the same (or closely related) underlying share or index to exploit differences in prices. Arbitrage takes advantage of inefficiencies in markets.

Beta: A measure of the volatility or systematic risk of a share compared to the market or index. Shares with betas higher than 1.0 can be interpreted as more volatile than the index.

Call (option): is a contract that gives the option buyer the right to buy shares at a specified price within a specific time period. The buyer of a call option is often speculating that underlying shares will rise.

Capital Allocation: How much of the fund’s assets are allocated to a particular investment (strategy).

Delta: How much an option’s premium price will change given a move in the underlying share price. The higher the delta, the more likely an option will end in the money.

Derivative: for example an option or warrant, is a contract with a fixed expiry date, between two or more parties where the derivative value is based upon an underlying asset. Derivative trading is when traders speculate on the future price action of a share via the buying or selling of derivative contracts.

Dispersion: dispersion trading capitalizes on the difference between implied and realized volatility, which is greater between index options than between individual stock options. Savin therefore often sells index options and buys individual stock options.

Diversification: a risk management technique that mitigates risk by allocating investments across different financial instruments. The purpose of this technique is to maximize returns by investing in different areas that would yield higher and long term returns.

Equity Market Correlation: How an underlying share moves in relation to the market or index.

Gamma: Describes the rate of change in an option’s delta relative to a move in the underlying asset’s price. If you are gamma-long, you will make money if the underlying moves, and conversely lose money if the underlying shares do not move.

Geography: The regions where Savin invests. Currently only in US and Europe.

Holding company: The highest company in a group of companies. A holding company is also called a parent company, and can be a collection of unrelated public and private companies.

Implied volatility: The market’s forecast of a likely movement in the underlying shares. Supply, demand and time value are major determining factors for calculating implied volatility.

Intrinsic Value: the intrinsic value of an asset usually refers to a value calculated on simplified assumptions. For example, the intrinsic value of an option is based on the current market value of the underlying instrument, but ignores the possibility of future fluctuations (time value or premium).

Long: a long position means that you own the stock (or own the warrant, bond, option). Investors maintain long positions in the expectation that the stock will rise in value in the future.

Option: A contract between two people that gives the holder the right, but not the obligation, to buy or sell a stock at a specific price, prior to a specific date, referred to as the contract expiration date.

Portfolio: The collection of financial investments Savin has.

Put (option): is a contract giving the option buyer the right, but not the obligation, to sell a specified amount of an underlying stock at a predetermined price within a specified time frame. The buyer of a put option is speculating that the underlying share price will decline.

Quantitative trading is a type of strategy that relies on mathematical and statistical models to identify opportunities. Frequently referred to as ‘quant trading’, or sometimes just ‘quant’

Realized volatility: (or historical volatility) is used in the context of derivatives and is a measures what actually happened in the past regarding share/index price movement.

Short: the opposite of a long position is a short position. A short position is generally the sale of a stock you do not own, and hope to buy back at a lower level.

Straddle: You own a straddle when you buy both a call and a put for the same strike price on the same expiration date. This (long straddle) strategy generates profit on large price changes, regardless of direction.

Systematic strategy: a trading or investment strategy that relies on a set of defined rules (and/or signals) to enter and exit trading positions and manage investment risks.

Tail risk: Risk of a loss occurring due to a rare negative market event, for example a market crash.

Time value (or premium) is the amount an investor is willing to pay for an option above its intrinsic value. This amount reflects hope that the option’s value increases before expiration due to a favorable change in the underlying price.

Theta: measures the rate at which an option loses its time value as the expiration date draws near. It is the rate of decline in the option price over time.

Uncorrelated returns: Returns that are generated independent of market direction or sentiment.

Underlying shares: Same as shares, security or stock. Often called ‘underlying’ as it is the reference for pricing related instruments like options and warrants.

Universe: a pool of selected assets that Savin monitors.

Vega: increase or decrease in an option premium based on a 1% change in implied volatility. Vega is a derivative of implied volatility.

Volatility: Shows the range to which the price of a security may increase or decrease.

Warrant: A warrant gives the holder the right to purchase a company’s stock at a specific price and at a specific date. A stock warrant is issued directly by the company. When an investor exercises a warrant, the shares that fulfill the obligation are not received from another investor but directly from the company.