Areas of Opportunities for Value Investors: The Cycles of Investment Fashion - The Risk-Arbitrage Cycle

Many participants in specialized areas of investing such as bankruptcy and risk arbitrage have experienced inferior results in recent years. 

• One reason is the proliferation of investors in these areas. In a sense, there is a cycle of investment results attendant on any investment philosophy or market niche due to the relative popularity or lack of popularity of that approach at a particular time. When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns. 
• Ultimately the good investment performance, which was generated largely by those who participated in the area before it became popular, ends and a period of mediocre or poor results ensues. As poor performance continues, those who rushed into the area become disillusioned. Clients withdraw funds as quickly as they added them a few years earlier. The redemptions force investment managers to raise cash by reducing investment positions. This selling pressure causes prices to drop, exacerbating the poor investment performance. Eventually much of the "hot money" leaves the area, allowing the smaller number of remaining investors to exploit existing opportunities as well as the newly created bargains resulting from the forced selling. The stage is set for another up-cycle. 

Risk arbitrage has undergone such a cycle during the past several years.

• In the early 1980s there were only a few dozen risk arbitrageurs, each of whom managed relatively small pools of capital. Their repeated successes received considerable publicity, and a number of new arbitrage boutiques were established. The increased competition did not immediately destroy the investment returns from risk arbitrage; the supply of such investments increased at the same time, due to a simultaneous acceleration in corporate takeover activity. 
• By the late 1980s many new participants had entered risk arbitrage. Relatively unsophisticated individual investors and corporations had become significant players. They tended to bid up prices, which resulted in narrower "spreads" between stock prices and deal values and consequently lower returns with more risk. Excess returns that previously had been available from arbitrage investing disappeared. 
• In 1990 several major takeovers fell through and merger activity slowed dramatically. Many risk arbitrageurs experienced significant losses, and substantial capital was withdrawn from the area. Arbitrage departments at several large Wall Street firms were eliminated, and numerous arbitrage boutiques went out of business. This development serves, of course, to enhance the likelihood of higher potential returns in the future for those who continue to play. 

It is important to recognize that risk-arbitrage investing is not a sudden market fad like home-shopping companies or closed end country funds.

• Over the long run this area remains attractive because it affords legitimate opportunities for investors to do well. 
• Opportunity exists in part because the complexity of the required analysis limits the number of capable participants. 
• Further, risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. 

Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.