In 1907 Royal Dutch Petroleum and Shell Transport agreed to merge their interests while remaining distinct entities. 60% of the cash flows of the combined enterprise were attributable to Royal Dutch shareholders in the Netherlands; the remaining 40% were attributable to Shell shareholders in Britain. Because of this fixed arrangement, one would expect the market cap of Royal Dutch to be precisely 1.5 times greater than Shell’s.
Long-Term Capital Management discovered that this price relationship did not usually hold. If it went up to 1.53 times, LTCM would short Royal Dutch and buy Shell. This resulted in a profit once prices returned to parity.
According to Donald MacKenzie, author of An Engine, Not a Camera, several arbitrageurs had mimicked LTCM’s portfolio of relative value trades as well as convergence trades (for instance, buying “off-the-run” Treasuries and shorting “on-the-run” Treasuries). When Russia defaulted on its bonds, panicked investors bought large amounts of on-the-run Treasuries, thereby creating large losses on convergence trades. LTCM copycats liquidated portfolio assets to reduce risk exposure; they even sold out of relative value arbitrages that were unaffected by the recent “flight to quality.” Selling Shell and covering Royal Dutch short positions drove prices further away from parity (Scruggs 34).
If MacKenzie is right, relative value arbitrage is profitable except under very unlikely contingencies. I have identified one current opportunity; however, it is not suitable for passive minority investors.
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[...] shares and Shell Transport ordinary shares has broadly matched the 60/40 interests set forth in the scheme of amalgamation. When this relationship has deviated from parity, it appears to have done so for reasons external [...]