Polygon Convertible Opportunity Fund Up 11% in 2011

Polygon manages approximately $5billion. Their convertible fund had a spectacular 2011, outperforming the US Convert Arbitrage Index by over 1300 bps. The fund has outperformened the index in 2009 and 2010 as well. The fund did this with a sharpe ratio of 3.0!

Below is fund commentary. You can also view OPolygon’s Equity opps funds, which we posted here.

It is an annual tradition that email inboxes are flooded with outlook pieces providing forecasts and predictions for the coming year and we have dutifully sought to craft our own insightful guide for 2012. This is no simple task, as recent years have demonstrated, and the macro picture seems even more uncertain now than it was at the beginning of 2011. Apparently, much of the research community sees things differently and strongly held views and forecasts are as forthcoming as they are varied. As a result of this incongruity, I found myself reflecting on the value of “outlook” pieces rather than effectively documenting my thoughts on the coming year and a considerable portion of the letter is devoted to this topic as a consequence. Unfortunately, the timing of this piece was also affected and is more coincident with the dawning of the Chinese New Year than it is with the first days of 2012.

A good friend forwarded me an interesting article from the New York Times entitled “A World in Denial of What it Knows”1 in which the author argues that many plain truths are evident but we willfully choose to ignore them. More specifically, he references the Euro in this light: “If truth be told (but it so rarely is!), the euro cannot work and could never have worked.”
He describes this “truth” as an unknown known – borrowing from author Fintan O’Toole (who himself clearly owes Donald Rumsfeld). He defines these unknown knowns as things which are: “…easily knowable, or indeed known, but which people chose to “unknow.” The author urges us to “unknow less and know a little more” – arguing we should accept as fact that the Euro is doomed to failure (and to do otherwise is akin to sticking our heads in the sand). Whilst I believe the Euro experiment to be deeply troubled I found his confidence in its demise concerning. I also recognized in it a commonality with many of the outlook pieces I had just read: they also contained a strongly held and articulated opinion about events, many of which I viewed as unpredictable (or unknowable even). The predictions vary from the life expectancy of the Euro and the coming implosion of the Chinese real estate market to the timing of an imminent Greek default or Italian banking crisis. There was only one outlook piece I read which was truly concerned with the “shelf life” of what they had written.
Economic research, like the broader media, appears to have followed a more sensationalist path in recent years. Alongside more spectacular news, we encounter economic predictions that are more dramatic and convictions (in opposing directions) which are more strongly held. It is easier to find an article vociferously supporting one side of a point than to find an agnostic or hesitant publication offering a more balanced perspective. Research houses appear so committed to making specific forecasts that this tendency has led to a proliferation of “surprise” predictions to complement the general outlook. Rather than directly admitting the fallibility of their views, analysts prefer to predict the “surprises” by which their very own forecasts might be undone.

Forecasts and predictions are a fact of life in our business and invaluable to the investment process. It is clearly sensible to handicap issues of importance to the capital markets (and to prepare for even the unlikeliest of outcomes at the same time) but I think one of the greatest mistakes we can make as an investor is to hold too strongly an opinion. Research demonstrates that an observer’s predispositions will become more strongly held when positive reinforcements are encountered, yet, that same observer ignores data at conflict with their thesis. I am now finally coming to my central point which is that an open mind and a great deal of patience were perhaps our greatest assets in 2011.

1”A World in Denial of What It Knows” – Geoffrey Wheatcroft, The New York Times, 31 Dec 2011.

We were (and remain) defensively positioned. Our focus is on catalyst driven opportunities and in maintaining a nimble and reactive book. Our positioning has, in rosy months, guarded against ugly outcomes we had believed unlikely, and in periods when the world cries “the sky is falling” it has provided us the
latitude to adopt a more positive view than pundits deemed sensible. The European sovereign crisis dominated newsflow and risk appetite in 2011 as I am confident it will do again in 2012. I don’t know if the flawed Eurozone experiment will ultimately come to a fatal end, although I suspect a break-up would prove a far more expensive and damaging outcome than to forge onwards with an imperfect union. It is also difficult to gauge the depth and length of a potential European recession with banks expected to de-leverage against a backdrop of near unprecedented austerity. Who will govern France and will it affect European unity? How will the ECB behave with Draghi at the helm of a new six-member board (new in that it will soon include not even a single member who was on the board 24 months ago)? With such uncertainty, it is no surprise we are keen to maintain our nimble positioning.

With that said, there are a number of reasons to be more optimistic about 2012 than 2011, including a credit market which currently prices in a far more dire outlook than it did 12 months previously, a convertible market which is now significantly cheaper than it was at this time last year, and a competitive landscape (particularly in Europe), which remains highly attractive.

Convertible Valuations

The convertible market has for the last seven months traded in sympathy with the general appetite for risk, and valuations have risen and fallen broadly alongside moves in the equity and credit markets. The U.S. remains the largest and deepest convertible market and has shown the least sign of strain, both on valuations and with respect to liquidity. European convertible bonds have steadily cheapened in recent months and the performance for European funds (both outright and hedge funds), has been poor, leading to small outflows. The U.S. market is at its cheapest since August 2010 while European bonds have not been this inexpensive since 2008 (see Charts 1 and 2).


Liquidity in Europe, particularly in the more esoteric names, has declined, sell side commitment to the product is not as strong as it was a year ago and both
capital and head-count have been reduced, in some cases very significantly. As a result, movements in bond prices and valuations are more dramatic as dealers are uncomfortable carrying inventory (and therefore prices adjust quickly to find

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