How to launch a convertible arbitrage hedge fund: strategy, returns and Cayman fund structure

A convertible arbitrage hedge fund buys convertible bonds and sells short the issuer's shares to hedge the embedded equity option, earning returns from bond carry, from trading the hedge as the share price moves, and from buying convertibles below their theoretical value. The strategy had a strong 2025: the HFRX Convertible Arbitrage Index returned 12.78% for the year, global issuance reached a level estimated at around twice its historical average, and several dedicated managers reported double digit gains. Launching a fund to run it means building the parts of the strategy that a bank desk or multi-manager platform previously supplied: convertible financing and stock borrow in the fund's own name, an independent pricing process for instruments that trade infrequently, risk reporting on equity, volatility and credit exposures, and dealing terms that match how quickly the book can be reduced in stress.

Convertible arbitrage is one of the few hedge fund strategies whose opportunity set is created directly by corporate financing decisions. When companies issue heavily, the strategy has more to work with, and the last two years have shown that clearly. What decides whether a new convertible fund lasts is not the quality of the first year's trades but whether the borrow, financing and valuation framework holds when volatility and credit spreads move against the book at the same time.

David Lloyd, Chief Executive Officer at CV5 Capital

Executive summary

• Convertible arbitrage pairs a long convertible bond with a short position in the issuer's equity, sized to the bond's sensitivity to the share price. Returns come from coupon carry, short rebate, gamma trading and mispricing of the embedded option.
• The HFRX Convertible Arbitrage Index returned 6.82% in 2024 and 12.78% in 2025, according to Hedge Fund Research. The strategy is not one directional: the same index fell 1.59% in September 2026, and the strategy lost roughly a third of its value in 2008 by contemporaneous industry estimates.
• Supply is the main driver of opportunity. Man Group estimated 2025 issuance at US$166 billion, around twice the average, with approximately US$180 billion of maturities to be refinanced through 2026 and 2027.
• Managers active in the strategy include LMR Partners, Linden Advisors, Context Partners and Acasta Partners, the convertibles business formerly part of Polygon. LMR's convertible fund was reported to be up around 30% for 2025 by late October.
• An open-ended convertible fund that issues redeemable interests falls within the Cayman Mutual Funds Act, not the Private Funds Act, and CIMA's rules on the calculation of asset values and the contents of offering documents shape its valuation and disclosure.
• The launch work is specific to the strategy: convertible financing and borrow on the short leg, a pricing hierarchy for convertibles, Greeks based risk reporting, credit analysis of each issuer, and liquidity terms matched to the financing.

How convertible arbitrage works

A convertible bond is a corporate bond that the holder can exchange for a fixed number of the issuer's shares. Because the holder owns that conversion right, the bond pays a lower coupon than the same issuer's straight debt. Economically, the instrument is a bond plus a call option on the issuer's equity.

The convertible arbitrage manager buys the bond and sells short a quantity of the issuer's shares equal to the bond's delta, the sensitivity of the convertible's price to a change in the share price. The result is a position that is broadly neutral to small moves in the share price but long the option's convexity: as the shares rise, the bond's delta increases and the manager sells more shares at higher prices; as the shares fall, the delta decreases and the manager buys shares back at lower prices. That rebalancing captures realised volatility, which is the core of the strategy.

Four sources of return are combined in a typical position:

• Carry. The bond's coupon plus the interest earned on the short sale proceeds, less the cost of borrowing the shares and the cost of financing the bond.
• Gamma trading. Profit from rebalancing the hedge when realised volatility in the shares exceeds the volatility implied in the convertible's price.
• Valuation. Buying convertibles, often at new issue, at a discount to their theoretical value and holding them as that discount narrows.
• Corporate events. Takeovers, early redemptions and conversions on improved terms, which can crystallise value earlier than expected.

Variations on the strategy

Most dedicated convertible managers combine these approaches and adjust the mix as the market moves. The choice matters for fund formation because it determines the instruments the offering document must permit, the counterparties needed and the valuation sources the administrator will use.

Why the opportunity has widened

Convertible arbitrage depends on supply. New convertibles are frequently priced at a discount to their theoretical value to attract buyers, and arbitrage funds are a large part of the buyer base for new issues. When issuance is high, the opportunity set grows; when it dries up, managers compete for a shrinking pool of bonds.

Supply rose sharply in 2025. Man Group's Q2 2026 hedge fund strategy outlook put 2025 issuance at US$166 billion, around twice the average, followed by US$38 billion in January and February 2026 before March slowed to US$2 billion. Numerix put 2025 global issuance at roughly US$167 billion across 264 deals. Estimates differ according to the data provider and the cut off date, but each source describes 2025 as the strongest year for issuance in several years.

Two features of the current market support supply beyond the immediate cycle. First, higher interest rates make the lower coupon on a convertible more valuable to issuers than it was when straight debt was cheap. Second, a large volume of debt raised in the low rate period is approaching maturity: Man Group estimates approximately US$180 billion of maturities to be refinanced through 2026 and 2027, and convertibles are one of the routes issuers use to refinance.

Volatility is the other input. Man Group's outlook notes that the strategy benefits from elevated single stock realised volatility, which drives gamma trading profits, and that merger activity helps where bonds are redeemed early or converted on improved terms. It maintained a positive view on the strategy in its Q2 2026 outlook while noting that, as more convertibles trade like corporate bonds, more hedging is needed.

The return profile and its risks

Published index data give a reasonable picture of the strategy's recent experience. Index figures describe a group of funds; they are not a forecast and do not represent the performance of any individual fund.

Three conclusions follow for a manager presenting the strategy to allocators.

First, the attraction is the shape of the return rather than its size in any one year. A delta hedged convertible book is designed to earn carry and volatility returns with limited sensitivity to the direction of the equity market, which is why allocators use the strategy as a diversifier alongside equity and credit exposure.

Second, the principal risk is not equity direction but a combination of events: credit spreads widening, bond floors falling, liquidity in convertibles disappearing and financing being withdrawn at the same time. That combination is what produced the 2008 losses, when leveraged funds were forced to sell into a market with few buyers. The funds best placed for the 2009 recovery were generally those that had kept their financing and avoided forced selling.

Third, the strategy is crowded at times. Large inflows, as in 2025, compress the discount at which new issues are priced and increase the risk that many funds need to sell the same bonds at once. A manager's account of how it sizes positions, limits concentration and manages liquidity is therefore as important to allocators as its return history.

Managers active in convertible arbitrage

The strategy is run by dedicated specialist firms and by teams within multi-strategy managers. The firms below have been publicly reported as active in convertible arbitrage. The figures are as reported in the press on the dates shown; they have not been verified by CV5 Capital, and inclusion is not an endorsement or a recommendation.

Two points stand out from the reported group. The reported convertible managers run concentrated, specialist businesses rather than large diversified platforms, which shows that the strategy can be built around a focused team. They have also, in most cases, operated through several market cycles, and allocators will compare any new manager against that record. A team leaving a bank desk or a multi-manager pod should expect to show how its process will work without the parent's balance sheet, borrow and allocation access behind it.

What a convertible arbitrage fund needs at launch

The general financing architecture of an arbitrage fund, including repo, haircuts, margin and the liquidity buffer, is covered in our guide on how to launch a relative value hedge fund. The points below are the ones specific to convertibles.

Financing the long leg

Convertibles are normally financed through the prime broker, and the haircut depends on the credit quality, size and liquidity of each issue. Smaller, lower rated and unrated convertibles attract materially higher haircuts, and prime brokers can change them at short notice. The fund should agree the margin methodology in writing, understand whether long convertibles and short equity are margined together, and model how much capital it would need if haircuts on its weakest bonds increased sharply. Our article on leverage limits, margin authority and prime brokerage protections sets out the governance around those terms.

Borrow on the short leg

The hedge depends on borrowing the issuer's shares. For smaller issuers, and where many arbitrage funds hold the same convertible, borrow can be scarce, expensive or recalled. A borrow recall forces the fund either to buy back the hedge, leaving the bond unhedged, or to sell the bond. Borrow availability and cost should be part of the decision to buy each new issue, and the fund should track concentration of borrow by issuer.

Counterparty structure

A single prime broker is simpler at launch but concentrates financing, borrow and custody with one firm. Many convertible funds add a second prime broker once assets justify it. The fund's documents should also address where unencumbered assets are held and the extent of rehypothecation, which we cover in prime broker counterparty risk, rehypothecation and segregation.

Valuation of convertibles

Convertibles trade over the counter and many issues trade infrequently, so the fund needs a written pricing hierarchy: independent pricing services first, then broker quotes, then a model price where neither is reliable. CIMA's Rule on the Calculation of Asset Values for regulated mutual funds requires the net asset value to be calculated by a party independent of the investment manager. Where the manager supplies a model price, the administrator needs the model inputs, in particular the volatility and credit spread assumptions, and a process to verify them. Pricing both legs of each position on a consistent basis avoids NAV movements caused by timing differences rather than by the position itself.

Risk reporting

Allocators expect a convertible manager to report exposures in the terms the strategy uses: net delta, gamma, vega, credit spread sensitivity and interest rate sensitivity, together with gross and net leverage, concentration by issuer and sector, and the share of the book in issues below a stated size or rating. Reporting should be produced from the same data the administrator uses for valuation, so that risk and NAV reconcile.

Liquidity terms

Dealing terms should reflect how long it would take to reduce the book in a stressed market, not in a normal one. Monthly dealing with a notice period, often combined with a gate, is common for convertible funds; less liquid or credit oriented books typically need longer notice or quarterly dealing. The analysis behind the choice should be recorded, as described in our hedge fund liquidity stress testing framework.

The Cayman regulatory framework

A convertible arbitrage fund is normally open ended: investors can redeem their interests periodically. An open ended fund that issues redeemable interests falls within the Mutual Funds Act. The Private Funds Act applies to closed ended funds, which is not the usual structure for this strategy.

Regulation under the Mutual Funds Act brings the CIMA rules that shape how the fund is documented and operated. The Rule on the Contents of Offering Documents requires the offering document to describe the investment strategy and its limits, the material risks, and the techniques, instruments and borrowing powers the fund may use. For a convertible fund that means describing short selling, leverage and how it is measured, credit default swaps and other hedging instruments where used, the risk of borrow recall and haircut changes, and the valuation approach for instruments priced by model. The Rule on the Calculation of Asset Values governs the independence of the NAV calculation and the treatment of manager supplied prices.

Registration with CIMA is a regulatory status, not an endorsement of the fund, its strategy or its manager. The manager also remains subject to the rules of its own home jurisdiction, including any registration requirements for advising the fund and the rules on marketing it to investors.

Common mistakes

• Assuming the financing and borrow terms available on a bank desk or a multi-manager platform will be offered to a new fund on the same basis.
• Building a book weighted to small, lower rated issues where haircuts, borrow and liquidity are least reliable, without limits on that exposure.
• Relying on the manager's own model prices for illiquid convertibles without independent verification by the administrator.
• Offering monthly dealing on short notice against a book that would take longer to reduce in stress.
• Writing an offering document that describes the strategy in general terms but omits short selling, leverage measures, borrow recall risk and model based valuation.
• Presenting a single strong year of returns to allocators without showing how the process performs when volatility falls or credit spreads widen.

The CV5 implementation perspective

CV5 Capital provides regulated infrastructure through which third party managers establish and operate Cayman funds. A convertible arbitrage strategy is a traditional hedge fund strategy and is established within CV5 SPC; CV5 Digital SPC is reserved for digital asset strategies. The manager retains responsibility for investment decisions. CV5 Capital is not the investment manager of the strategies on its platforms.

Through the Cayman hedge fund platform for emerging managers, a convertible manager has the regulated vehicle, an independent board, and coordinated fund administration, audit, banking, custody and compliance arrangements from day one. That allows the launch effort to concentrate on what is specific to the strategy: prime brokerage and borrow, the pricing hierarchy agreed with the administrator, risk reporting, dealing terms and the offering document disclosure set out above. Where fund terms, service providers and onboarding requirements are ready, a launch on the platform can typically be completed in approximately three to four weeks; prime brokerage onboarding for a new fund often sets the pace.

Key takeaways

• Convertible arbitrage earns carry, volatility and valuation returns from long convertibles hedged with short equity.
• The HFRX Convertible Arbitrage Index returned 12.78% in 2025, supported by record level issuance and elevated single stock volatility; the strategy remains exposed to combined credit, liquidity and financing stress.
• Specialist managers such as LMR Partners, Linden Advisors, Context Partners and Acasta Partners set the benchmark against which allocators will assess a new fund.
• Secure convertible financing and stock borrow in the fund's own name, with written margin methodology and limits on the least liquid issues.
• Agree an independent pricing hierarchy with the administrator and report risk in delta, gamma, vega and credit terms.
• Structure the fund as an open ended fund under the Mutual Funds Act, with disclosure and dealing terms that reflect the strategy's financing and liquidity profile.

Frequently asked questions

What is a convertible arbitrage hedge fund?

A convertible arbitrage hedge fund buys convertible bonds and sells short the issuer's shares to hedge the equity option embedded in each bond. It aims to earn the bond's carry, profits from rebalancing the hedge as the share price moves, and gains as undervalued convertibles move towards their theoretical value, with limited exposure to the direction of the equity market.

How did convertible arbitrage perform in 2025?

The HFRX Convertible Arbitrage Index returned 12.78% in 2025, according to Hedge Fund Research, after 6.82% in 2024. Several specialist managers reported larger gains; LMR Partners' convertible fund was reported to be up around 30% by late October 2025. Index and individual fund returns are not a guide to the future performance of any fund.

Which hedge funds run convertible arbitrage strategies?

Specialist firms publicly reported as active in the strategy include LMR Partners, Linden Advisors, Context Partners and Acasta Partners, formerly part of Polygon Global Partners. Convertible arbitrage is also run by teams within multi-strategy hedge fund managers.

What are the main risks of convertible arbitrage?

The main risks are a combination of widening credit spreads, falling liquidity in convertibles, higher financing haircuts and stock borrow recalls, which can occur together in a market stress and force funds to sell. Falling volatility reduces gamma trading returns, and heavy inflows into the strategy can reduce the discount at which new issues are priced.

Is a Cayman convertible arbitrage fund regulated under the Mutual Funds Act or the Private Funds Act?

A convertible arbitrage fund is normally open ended, with investors able to redeem periodically, and an open ended fund issuing redeemable interests falls within the Mutual Funds Act. The Private Funds Act applies to closed ended funds.

Who values a convertible arbitrage fund's positions?

Under CIMA's Rule on the Calculation of Asset Values, a regulated mutual fund's net asset value must be calculated by a party independent of the investment manager. Where the manager supplies model prices for illiquid convertibles, it must provide the supporting inputs, and the administrator must take reasonable steps to verify them.