Why A Resurgence In Dealmaking Is Working Wonders For This Hedge Fund Strategy

Why A Resurgence In Dealmaking Is Working Wonders For This Hedge Fund Strategy
Stéphane Renevier, CFA

over 2 years ago5 mins

  • When one company acquires another, it buys the stock at a premium to the current market price, only for the stock price to catch up when the deal closes.

  • Merger arbitrage strategies go long on the target company and short on the acquirer when the deal is announced, and they make money every time it succeeds.

  • And despite some risks, merger arbitrage strategies do seem quite attractive right now – and there are three ETFs you can invest to take advantage.

When one company acquires another, it buys the stock at a premium to the current market price, only for the stock price to catch up when the deal closes.

Merger arbitrage strategies go long on the target company and short on the acquirer when the deal is announced, and they make money every time it succeeds.

And despite some risks, merger arbitrage strategies do seem quite attractive right now – and there are three ETFs you can invest to take advantage.

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Mergers and acquisitions dropped off a cliff last year, and they’re yet to return to former glories. But with stock markets so strong and loans so cheap, it might only be a matter of time before dealmaking picks up again. And that’ll give you a prime opportunity to benefit from one of hedge funds’ favorite strategies: “merger arbitrage”.

What is merger arbitrage?

When a company wants to buy another company, it makes an offer to purchase the stock at a premium above the current market price. That’s because it wants to incentivize shareholders of the target company to accept the deal.

But here’s the thing: it’s not certain that the deal will actually succeed, so the share price doesn’t immediately jump to the offer price. The difference between the two prices is called the “spread”, and the bigger the risk that the deal fails, the bigger the spread. If the deal does succeed, the price of the target company eventually rises to the offer price.

So some of hedge funds’ sharpest minds came up with a great idea: if they bought the shares of the target company and sold the acquirer’s, they’d only be taking a position on the success of the deal – and not on other factors, like the rise and fall of the stock market. For every deal they called correctly, then, they’d add to their profits.

Why is merger arbitrage so appealing right now?

Firstly, the outlook for the strategy looks promising. Merger and acquisition (M&A) activity has been relatively low considering how strong stocks’ bull market has been, but a pickup in activity is looking likely: stock markets still have strong momentum, financing costs are low, and trade tensions – which have prevented so many deals from happening in the last two years – have softened. More M&A deals would mean more opportunities, a higher level of diversification, and probably better risk-adjusted returns for the strategy.

Second, the strategy could be a good way of diversifying your portfolio. Merger arbitrage has a low correlation to stocks, bonds, commodities, and crypto. Better yet, its short positions on buyers means a crash in stocks should end up balancing out any losses it sustains on its long positions. In fact, the strategy is commonly classified as an “absolute return” strategy, meaning it’s expected to perform well in any market environment.

Third, the strategy’s easy to implement. Investors can use publicly listed exchange-traded funds (ETFs) to access a large amount of deals for a relatively small fee, across different sectors, regions and deal sizes. We’ll get onto that shortly…

What are the risks?

Deals can and do fail, whether because shareholders don’t give the target company the green light, because there’s some regulatory issue, or because something entirely unexpected crops up. And when a deal fails, losses can be high – and generally higher than the gains when the deal succeeds. Of course, merger arbitrage funds mitigate that risk by diversifying across a wide number of deals, so even if one fails, the others should still succeed and losses are contained.

The biggest risk, then, is that many deals fail at the same time. That’s exactly what happened during the Covid crisis, when transactions fell apart, M&A activity was put on hold, and most merger arbitrage strategies suffered heavy losses. So while the strategy is uncorrelated to stocks most of the time, there are times when they’re both hit at the same time:

Merger Arbitrage ETF "MNA" has room to catchup stocks
Merger Arbitrage ETF "MNA" has room to catchup stocks

How can you roll out the merger arbitrage strategy?

Like we mentioned above, the strategy’s actually pretty easy to roll out using ETFs.

The first step is to choose between a passive merger arbitrage ETF or an active one. Active ones, like First Trust Merger Arbitrage ETF (MARB), actively seek out the best deals and avoid the ones unlikely to succeed, which means they should in theory achieve higher returns. But they haven’t actually outperformed passive ETFs in the past, and they’re a lot more expensive too (MARB has a hefty expense ratio of 2.3%). Passive ETFs, like Proshares Merger (MRGR) or IQ Merger Arbitrage ETF (MNA) not only have lower fees, but also a longer track record and higher liquidity, making them arguably a better choice for most investors.

The second step is to assess the fund’s risk profile by looking at metrics like the number of deals it invests in, how concentrated its position is in the 10 biggest deals, the sector and geographic exposure, and the market liquidity. All three ETFs above are quite well diversified, with their number of holdings ranging from 32 to 52 and a significant allocation across different sectors like IT, healthcare, industrials, and financials. They’re invested in countries other than the US too, like Germany and Canada.

The last step is to look at how the fund implements its short exposure. While MARB and MRGR take a short position on the acquiring companies' stocks directly, MNA shorts the broad stock market instead. What’s more, MNA holds a relatively small short position, meaning the strategy is more correlated to stocks – good in bull markets, but less so when they crash. That difference in implementation is a big factor in explaining the significant gap in performance between the two passive ETFs:

Not all Merger Arbitrage ETFs are equal
Not all Merger Arbitrage ETFs are equal

So if you’re looking for maximum diversification, I’d look at MRGR. But if you can tolerate a higher exposure to the broader stock market, I think MNA is a great option too – and I wouldn’t be surprised if it starts closing the gap on the S&P 500.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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