It is tempting fate to draw attention to such things, but April was the 18th consecutive positive month in the recent performance record of the Arbitrage Fund, an unbroken run that began in November 2008.

There has been a shift in the pattern of the contributions we see from our themes over that period. Given the scale of the change in the investment environment that has taken place in the meantime, this is hardly surprising. Further change is imminent, but not necessarily unhelpful. As we have pointed out previously, legislation to restrict the proprietary trading activities of the US Banks will also limit bank participation in arbitrage. As this report is written in mid May, the US Congress appears to be on the point of enacting such measures.

As in March, Merger Arbitrage produced the best performance, despite widening spreads, particularly on deals in the oil sector. There was a healthy list of strategic acquisitions announced in April such as HP‘s bid for Palm, Hertz’s approach to Dollar/Thrifty, and Shell’s bid for Arrow Energy. Financial buyers are back in the game too: Interactive Data Corporation, CKE Restaurants and Skillsoft have agreed to bids from Private Equity buyers backed by the Banks and Novell is the subject of an approach. This reflects the normalisation of the markets for High Yield and Bank debt, especially in the US, and stands to increase deal activity to a marked extent.

All four of our Fixed Income Arb managers were profitable. Given that the trend in volatility in fixed income reversed sharply in late April, this was a good outcome. Renewed concerns about European Sovereign debt became sufficiently intense that money market and short term interest rate spreads began to widen once more, much as they had done in 2008. The package of measures agreed between the Euro members on May 9th contained measures that will suppress this pressure. But the volatility jolt involved will throw up some interesting relative value opportunities.

The Mortgage Arb theme had a positive month, led by the return from the manager added this month. This fund was added to the portfolio partly as a result of his demonstrable trading skill, which has enabled him to make a strong initial contribution in a month in which Agency Mortgage markets were range bound.

Instrument Arbitrage had a neutral month and Volatility Arbitrage recorded a small loss. However, May has witnessed a sharp reversal in volatility across the board as the news of European structural weakness has brought a measure of dislocation and anxiety to financial markets. After the first two weeks of the month, the net impact of this on the Arbitrage portfolio is negative to the extent of just under 1%.

Five of our six themes were profitable in March, producing a strong overall result.

Merger & Event Arbitrage generated the best return. All four Fixed Income Arbitrage managers made money. Despite the traumas suffered by both Greek Bond investors and Greek citizens as they watch the EU rescue wrangle conclude, volatility in Government Bonds declined further. This is not to say that opportunity declined as there was money to be made from the continuing normalisation of price relationships across the volatility surface. March was the first month in which new US Treasury issuance was absorbed by a market free of influence from the QE programme. Whether this was the reason or not, participants report reduced appetite for new bonds and an increase in pricing concessions on new issues in order to encourage their absorption. This translates into wider spreads on the simplest form of the classic fixed income arb trade. In recent quarters, one of the four managers in the theme has lagged its peers systematically, and we have therefore redeemed this holding. There is no shortage of talent in the field.

Mortgage rates rose, but by slightly less than US Treasury yields, which suited the tilt in the optionality incorporated in one of our managers portfolios, but both of our Mortgage Arbitrage managers were profitable. Our second manager spent the month rebuilding his portfolio following the accelerated buyout of delinquent Freddie Mac bonds in February. In this theme too, we have initiated a manager change, adding a firm with a demonstrable trading aptitude.

Our Instrument Arbitrage manager finds markets particularly interesting when there is a marked change in the flow of investments into or out of the Asian region. Flows to Emerging Markets from the west have stepped up in recent weeks. Increasingly frantic media speculation about the prospect and timing of a possible change in China’s currency management programme has added further spice. Events elsewhere in the region have also produced anomalies in short term market reaction to Toyota’s recalls, the prospect of large scale capital raising by China’s big Banks, a disruptive earthquake in Taiwan and an unexplained explosion on a South Korean naval ship which killed 40 crew members. Convertible Arbitrage generated a small positive return.

Our Volatility Arbitrage manager lost money during this first month of his inclusion in the portfolio, although the impact was tempered by the limited 2% allocation. Equity market vol declined in the face of broad rises in the indices, fixed income vol fell as previously discussed and foreign exchange markets quietened down as anticipation of a move in the RMB grew.

We have added an additional Merger & Event Driven Arbitrage manager. This fund embraces complexity, but without surrendering liquidity and adopts an extremely thorough approach to the construction of its trades and to the diversification of its portfolio. We expect it to consider opportunities right across the market capitalisation range and to have wide geographic coverage.

Three of the larger themes in the portfolio contributed small gains in February. Their collective 70% weighting meant that these gains substantially outweighed the small loses made by the remainder.

Merger Arbitrage had a good month. Schlumberger bid for Smith, Air Products for Airgas, Merck bought Millipore, Coke bought Coke bottlers and the Xerox and Burlington Northern transactions closed. The pace of activity is rising. All three Convertible Arb managers made money, even though the environment was not particularly helpful in that credit spreads widened while volatility declined. Convertibles have become a stock pickers market once more.

Merger Arbitrage had a good month. Schlumberger bid for Smith, Air Products for Airgas, Merck bought Millipore, Coke bought Coke bottlers and the Xerox and Burlington Northern transactions closed. The pace of activity is rising. All three Convertible Arb managers made money, even though the environment was not particularly helpful in that credit spreads widened while volatility declined. Convertibles have become a stock pickers market once more.

Mortgage Arbitrage was a slight drag on the fund’s performance. As highlighted a month ago, an accounting change led two of the US Governments Mortgage Agencies to accelerate their buy out of damaged loans. Because of their high coupons, the bonds called in this process were typically trading above par, so unwary holders took a knock on the news. In addition to the direct losses, this created some dislocation, risk aversion and spread widening in certain mortgage bonds, which temporarily exaggerated the direct effect. A part, in fact the larger part, of the QE programme was executed by means of Fed purchases of mortgage bonds. This buying will formally end on March 31st although there is no indication that the Fed will sell any of its holdings in the foreseeable future: the exertion of downward pressure on mortgage costs remains a key policy goal. Obligingly, markets are pricing overall Agency Mortgage Bond spreads at historic lows.

We have redeemed our sole Multi-Strat Diversified Arbitrage manager. We remain convinced of his skills, but his fund lost a dominant client, raising its expense ratio above the threshold of acceptability.

In February, we added one manager to seed a Volatility Arbitrage theme with an initial 2% weighting. The environment in which Arb specialists operate continues to be benign. But the co-ordinated reflation policies brought to bear on the 2008/9 crisis are now generating uncoordinated recoveries with highly differentiated asset market consequences. The resulting pressures on sovereign credit, interest rates, foreign exchange and equity markets will throw up anomalies not just in the prices of these assets, but in the markets that trade the volatility of those prices as well.

By the middle of January, the posture of financial markets turned negative, pushing two of our themes into a small loss for the month. Two themes were neutral in their impact on the performance of the portfolio and the remaining two were sufficiently profitable to provide a positive return overall.

Convertible Arbitrage requires an assessment of stock valuations, credit spreads, interest rate movements and changes in volatility in order to identify opportunity. In January, volatility rose, as did credit spreads while interest rates and equity valuations fell. To complicate matters, all of these net changes on the month followed a period of change in the opposite direction in the first two weeks of January. One of our managers was caught out by the reversal and his returns pushed the theme into deficit. Merger Arbitrage was subject to a similar small scale negative impact from choppy price action.

By contrast, Fixed Income Arbitrage managers generally found the environment constructive. Sovereign credit is the big story everywhere. The fundamentals are the ultimate drivers of markets, but politics plays a big part too. In the Greek example, even if a Franco German bailout is the most likely finale, the interplay over the ‘remedies’ Greece must endure in the meantime produces market stress and market anomalies in equal measure. Analysts of the fundamentals look for the next most vulnerable credit. January witnessed a sharp increase in interest in buying long dated payer options in $ & £. Japan is a cheap market in which to bet on higher long term rates. Interest in this area increased too. There are also reports of a revival in the creation of structured product purporting to enhance yield for retail savers. These conjure the necessary ‘yield’ from selling volatility. Their reappearance provides additional opportunities in this theme, even if it seems unlikely that the ultimate retail investors in question will get the outcome they have signed up for.

In Mortgage Arbitrage, January was a profitable month for our managers but February is proving to be more of a challenge. The majority of US mortgages are guaranteed by Agencies originally sponsored by Government and now effectively owned by the US taxpayer, GNMA (Ginnie Mae), FNMA (Fannie Mae) and FHLMC (Freddie Mac). The agencies buy back delinquent mortgages out of the pools of assets they have guaranteed. A proportion of these mortgages have been split into two, separating entitlement to receive the interest (Interest only – IO’s) from the right to the principal repayment stream. Fannie and Freddie have announced their intention to accelerate the buyback of damaged loans for which they are ultimately liable, reducing the number of coupons which the IO holders will receive and so reducing the value of these securities. In a sense, this heralds the end of the period in which spread capture was the best tactic for mortgage managers to employ. But we believe that both of the funds in which we invest have constructed their portfolios to include a range of idiosyncratic risks that offset one another and will not suffer lasting harm from this policy shift.

For December, all but one of the managers in the portfolio turned in positive results, generating profits in all themes and the fourteenth consecutive monthly gain for the Fund. In the year 2009 as a whole, all themes were profitable. Convertible Arbitrage and Mortgage Arbitrage contributed just over two thirds of the return. However, this should not obscure the fact that, together, the remaining four themes, contributed in excess of the Funds stated target return of LIBOR +300bp.

In the month, four themes contributed the bulk of the gains.

Merger Arbitrage made money in the month. Spreads have tightened during the year. This partly reflects the fact that, we did not see the wave of transactions predicted by the intermediaries. Lawyers and Investment Bankers see preparatory work well ahead of public merger announcements. Highly unscientific feedback from this community suggests considerable ongoing activity, which bodes well for 2010. So does the strength of corporate balance sheets overall. The Companies that make up the S&P index have doubled their net cash reserves to $1.5 t in the past 4 years. Of course they can make acquisitions with their own stock, but historically, large cash reserves tend to embolden potential acquirers.

Measures of volatility continued to decline in December with the Vix for example, now below its 10 year average. Convertible Arbitrage was profitable despite this headwind. New issuance in the US finished the year at $40bn, the lowest total in the past 10 years. In Asia, Japanese Companies were the largest issuers of CB’s. The level of new equity issuance in Asia in 2009 (60 IPO’s in HK) lays the foundation for an increase in the population of potential issuers in the year ahead. 2010 will not be a rerun of the exceptional return achieved last year. But the fact that the sector has not been flooded with paper, and valuations that have stabilised at levels that are still cheap to theoretical values, offers investors the prospect of a constructive start to 2010.

All four managers in Fixed Income Arbitrage were profitable in a month that saw US Treasury yields increase from 0.67% to 1.14% in the two year note and 3.21% to 3.85% in the 10 year. Towards the end of the year, liquidity diminished faster than the new supply of bonds, so the US Treasury had to provide increasing incentives to the Arb community to induce the level of support they needed the market to provide.

Our Mortgage Arbitrage managers captured the spread on their portfolios and made money from their interest rate hedges as well.

The Instrument Arbitrage manager finished off a strong year with a positive month. He saw opportunities in ADR arbitrage as the Tokyo market turned positive in tone and made money in dual listed stocks. The persistence of interesting spreads in these activities is a barometer of capital allocated to the field of arbitrage. When the Investment Banks have money to use for this type of proprietary trading, these spreads come under pressure. Happily, they are still at equivalent levels to those seen a year ago.

The November return was generated by four themes. The Mortgage Arb specialists absorbed the news that the Fed had reduced its commitment to the purchase of Government Agency issued mortgage backed debt by $25bn. In the original Quantitative Easing programme, purchases of $200bn of debt were scheduled as part of a wider initiative involving buying $1.25 trillion of Agency bonds as well but the impact of the programme is such that the last debt tranche is now considered unnecessary. So if purchases are now tapering off, is the unwinding of QE in sight? It appears not. Mortgage cost and availability has yet to normalise and remains a key issue in the Administration’s attempts to heal the housing market in the US. Newly created mortgage bonds are not flowing into the market in size and the Fed will not be a seller of mortgage paper at this stage. In this environment, our managers can build their portfolios around a core bloc of positive carry positions adding cheap optionality to enhance the returns.

The Fixed Income Arb theme was extended by the addition of a new Asian based fund which made a strong initial contribution to a positive theme performance. Their capital structure and intercompany books made the bulk of these returns. The fund only looks at fixed income securities, but ranges across the Asian region excluding Japan. Two of the remaining three managers were also solidly profitable in November.

Convertible Arb also made a strong contribution. In the US, issuance so far this year has run at an annual rate of approximately half of the 2008 level. In the spring of this year, when capital markets were just beginning to thaw, convertible issues were among the first sources of corporate funding available, and there are a number of instances where the issuers that were happy to raise money on the terms available then are having second thoughts now. So some of the issuance of that vintage is being bought back to be replaced by cheaper current sources of finance, and one of our managers generated a good portion of his return in the month from these buybacks. More generally, limited issuance combined with the retirement of existing paper creates a very positive market environment.

Instrument Arbitrage was the fourth contributor in November. ADR relationships to local markets were relatively consistent during the month, making the arb between them solidly profitable.

Multi Strat Diversified Arb represents a new theme, added to the portfolio on November 1st and initially comprising one manager. This firm concentrates on the Australian market and sets out to build a widely diversified portfolio of differing risk positions built around a core long volatility position. The satellite strategies include event opportunities, yield anomalies and convergence strategies. The market neutrality of the resulting portfolio is a primary objective of the analysis that goes into its construction.

Three themes made money in October. Our Mortgage Arb managers continued to harvest the historically attractive spreads available in the asset class. In addition, they have begun to consider the scope offered by mortgage securities to acquire cheap or even no cost option exposure to the possibility of rising short term rates in the US during 2010.

As the market impact of Quantitative Easing in US Government bonds fades, the environment for Fixed Income Arb has been dominated by large Government bond issuance. However, our managers report signs of rising levels of activity in trades that hedge future inflation. The inflation linked sector is the first place to look for this cover, but there is significant interest in long dated options that profit from higher nominal rates some years ahead. The Arb operators don’t particularly care what inflation is, but they like the opportunities that this kind of non specialist interest gives rise to.

In Convertible Arb, we added a new manager to the theme at the start of the month, an expert in the field of hybrid securities with a particular emphasis on Preferreds. Preferred stocks have been in the spotlight lately as a result of two connected factors, their past popularity among Bank issuers and the horrifying experience ‘enjoyed’ by many of the original owners of this Bank paper in the past year. Many of these either had no idea of the risks they were taking on or paid them no attention. The skill set of this manager consists of an ability to compare the valuation of the hybrid security with the valuation of the component credit, equity and interest rate elements and to understand the market context and its influence as well.

Merger and Event Arbitrage recorded a modest loss. Spreads on announced mergers have been through a phase of compression this year, but widened slightly in October. At the end of the first quarter, the gap between the valuation of the shares of a typical takeover target and the value of the offer was at record wide levels, in many cases in the 20-40% range. Today we are back to a more normal 5-15% span of opportunities. Yet there are still anomalies. For example, there is a tendency for the largest transactions to offer the widest spreads, partly because there is still much less capital available to absorb these opportunities today than was the case in the past. Transaction volumes have increased recently and we expect this trend to continue. Strategic buyers have been ramping up their activity, but October also saw the return of the financial buyer as TPG agreed to pay $5.2bn for IMS Health and, in a private transaction, the Anheuser Busch theme park business was sold to Blackstone for $2.7bn. For the first time since the financial crisis began leverage was available to enable these transactions to proceed.

Instrument Arb had a negligible impact on the month’s results.

September was the eleventh consecutive month of profitable performance for the Fund. In a neat display of symmetry, all eleven managers represented in the Fund were profitable, but two themes accounted for the majority of the return.

Convertible Arbitrage topped the list of contributors. In the US market, our managers report the normalisation of credit spreads, taking into account the cyclical environment. Volatility has found a trading range. The moving average of the VIX index for the past three months is in the high 20’s, compared to the long term average of just over 22. These factors create a positive environment for Convert Arb. Historically, such helpful conditions might have induced a large new issue calendar, and possibly sufficient new supply to cause a bout of indigestion. In September, $11bn was raised, the second busiest month of the year. Twelve issues worth $3bn appeared in the US, European markets absorbed $4.7 bn of new paper and Asia $2bn. Such volumes are not insignificant, but they are well below the average monthly issuance in 2008. In the past 6 months, the range of financing options has widened out giving the typical Corporate Treasurer access to equity and bond markets as well as convertibles. Governments have also been busy bolstering the balance sheets of Companies and Industries deemed systemically significant, a number of which might otherwise have issued converts. Changing supply conditions may well threaten the valuation of converts in future, but probably not while other markets remain so receptive.

Mortgage Arbitrage also had a strong month. Agency mortgage bonds still offer an attractive spread against US Treasuries despite the common role played by the US taxpayer in underwriting the creditworthiness of both. In addition to their interest rate, mortgage bonds include various embedded options arising from their flexibility on repayments. Prior to the final contracted maturity date, individual US mortgage borrowers can repay at will. Historically, falling yields on US Treasuries reduce the cost of new borrowing and encourage refinancing. Mortgage bond valuation models estimate this trend to predict early repayments. They then use these data to apportion separate values to the stream of income and the repayment of principal to which investors in mortgage securities are entitled. These two components of the return stream can be traded separately as Interest Only securities (or IO’s) and Principal Only bonds (PO’s). Today’s markets are still subject to unusual influences. Despite massive QE purchases, the cost of a new 30 year mortgage has not kept pace with treasuries. Lending criteria are tighter, and with something like 30% of US borrowers in negative equity many cannot refinance their existing mortgage without putting up more cash. So prepayments are much slower than the models predict and the managers who understand the impact of these underlying factors on extending interest streams have done well. To some extent, this is yesterday’s news, as the more thoughtful managers now turn their attention to the quest for cheap embedded options that offer sources of profit when QE ends. Given the right level of understanding, complexity can be your friend.

Volatility in Chinese stocks in thin summer trading thoroughly tested the risk management disciplines used by our Instrument Arb manager, and China A shares ended the month down 20%. In the circumstances, a flat performance was not a bad outcome.

All our other themes were profitable. Convertible Arbitrage led the field. In the US, new issues of convertible bonds went through a seasonal dip in number and volume, but buybacks, redemptions and tenders amounted to $6.5 bn, shrinking the universe of bonds outstanding by a bit over 1%. Credit spreads continued to tighten but higher credit quality issues caught up with spread tightening moves by weaker credits in the sector during August. One of our managers in this theme is an expert in gold mining stocks. This is by no means all he does, he just happens to think that gold is an interesting market and that a specialist in pricing volatility such as him, can make something of the opportunities thrown up in hybrid securities issued by producers of a metal whose price is itself very volatile. He had plenty to do in August as the gold price threatened to break out of the top of its recent trading range. A second manager in the theme has a good knowledge of those mid cap resource stocks in North America that have issued convertible bonds. Neither has any direct exposure to the underlying commodities produced by the companies in their universe. But these companies inevitably face significant volatility in their revenues which translates into stock price volatility, the raw material of which convert arb opportunities are made.

Two helpful factors came to light in early September. One relates to the environment for Arb specialists. Historically, with plentiful capital and high quality information flows, Banks have occupied the position at the top of the arbitrage food chain. Now capital is in short supply, and the prospect is that it will continue to be scarce. This was the clearest message emerging from the Meeting of the G20 Finance Ministers in London as they mounted a unified call for higher Bank capital requirements and, within that, a greater emphasis on tangible cash equity. Scarcity of equity will raise the hurdle rate required of all Bank assets, especially those, like proprietary trading in arbitrage, that tie up big chunks of balance sheet. Banks capital allocations to the activity will not return to pre crisis levels in this scenario and more scope for the arb specialists operating in the Hedge Fund sector will be one of the side effects.

The second positive development was Kraft’s bid for Cadburys. Strategic acquisitions have picked up in number through 2009, but this was the first instance that we have seen in over a year of a big bid, made without the prior agreement of the target company. Merger Arb has produced positive returns in 2009, and did well in August, but the reappearance of bidding wars will make this a substantially more profitable environment still.