What Drives the Performance of Convertible-Bond Funds?

This paper examines the performance of U.S. mutual funds that invest primarily in convertible bonds. Convertible-bond funds are popular investment vehicles, but their return process is not well understood. We analyze the complete universe of U.S. convertible-bond funds, proposing a set of multi-factor models for the return-generating process. Despite the well-known hybrid nature of convertible bonds, the return process of convertible-bond funds cannot be fully explained by factors typically related to stock and bond markets. We therefore consider additional variables accounting for the option-like character of convertible bonds, but find that those factors do not help explain convertible-bond fund returns. Multivariate cross-sectional analyses show a significant relation between a fund’s performance and its asset composition: the higher the difference in the percentage of assets invested in convertible bonds compared to the percentage invested in stocks, the higher the performance, on average. We show that this result can be explained by factors associated with investment opportunities in the convertible-bond market and trading strategies related to convertible arbitrage, as typically performed by hedge funds. Overall, convertible-bond fund performance measured by alpha is comparable to a passive investment in stocks, bonds, and convertible bonds. This performance is the result of weak selection skills and successful timing strategies related to convertible arbitrage.