A Look at Merger-Arbitrage ETPs
By
Robert Goldsborough | 06-17-15 | 06:00 AM |
Global merger and acquisition activity has continued unabated, and as 2015's first half comes to a close, the year looks to be the busiest year for M&A activity since before the financial crisis. With record-low interest rates and uncertainty regarding just when the U.S. Federal Reserve will raise interest rates, deals have continued, both by financial buyers and by strategic acquisitors.
Among the big M&A deals announced this year have been Berkshire Hathaway's H.J. Heinz unit's acquisition of 
Kraft Foods (KRFT), Charter Communications'(CHTR) bid for Time Warner Cable (TWC), Avago Technologies' (AVGO) plans to acquire Broadcom (BRCM), and AbbVie's (ABBV) recently closed deal to purchase Pharmacyclics. While the biggest headwind to further deals may be rich stock market valuations at present for potential acquisition targets, historically low debt costs are continuing to create favorable conditions for more deals. Also, corporate balance sheets remain flush with cash. Even private-equity deals are starting to pick up. Although recent deals that have been announced are nowhere near the size of the flurry of buyouts that occurred in the 2005-08 time frame, the recent LBO of Informatica (INFA) suggests that larger private-equity deals could be on the horizon.
One way that investors can capitalize on heated deal activity is to seek to benefit from merger-arbitrage strategies, which involve exploiting the gap between the proposed purchase price for an acquisition target and the price at which it is trading after the deal's announcement but before its closing. A growing number of exchange-traded products have come to market in recent years to offer exposure to merger-arbitrage strategies. Merger-arbitrage strategies historically have offered attractive risk-adjusted returns, although there is risk associated with them, as there is no free lunch in the market. M&A-oriented products can offer bondlike returns that are typically uncorrelated with equity or bond market performance. And investors can expect better performance from merger-arbitrage funds in an environment of heightened deal activity because it offers index providers and managers more deals to invest in. Without a reasonable number of deals, the products would end up holding more cash.
Given the blizzard of recent M&A activity, it's a good time to take a look at the different strategies that have been packaged in the ETP wrapper and to see how they have done.
Under the HoodMerger-arbitrage strategies provide exposure to deal risk--the risk that an announced deal might fall through. In general, deal risk lessens in an improving macroeconomic environment--when there is less uncertainty. Although institutional investors have used merger-arbitrage strategies for many years, passively managed merger-arbitrage strategies have been rolled out in the ETP wrapper only in the past several years. The strategies fit into one of two buckets. Either a product will track an index that takes long positions in a takeover target and shorts the acquiring company or it will track an index that takes long positions in deal targets and then broadly shorts the global equity markets as a partial equity market hedge.
The largest U.S. merger-arbitrage ETP is IQ Merger Arbitrage ETF (MNA), an exchange-traded product that launched in 2009 and tracks a benchmark that IndexIQ manages of announced takeover targets. The index also shorts the global market. Unlike other ETPs, MNA also includes global deals, which is why the fund holds a company like British soda can maker Rexam PLC, which is the subject of a pending acquisition from Ball Corp (BLL). MNA charges 0.76%.
Another option is an exchange-traded note issued by Credit Suisse (CS). Credit Suisse Merger Arbitrage Index ETN (CSMA) delivers the total return of a Credit Suisse-managed index that takes long positions in targets and short positions in acquisitors. Only deals within the United States, Canada, and Western Europe are represented. CSMA launched in October 2010 and charges 1.05%--a 0.55% investor fee plus another 0.50% index calculation fee.
Still another option is ProShares Merger Arbitrage ETF (MRGR), which tracks an S&P-managed index of deal targets and their acquisitors. MRGR's strategy is similar to that of the Credit Suisse ETN, except that MRGR takes actual long positions in acquisition targets and actual short positions in acquisitors (in stock-for-stock deals). MRGR's index is devoted to developed-markets deals and effectively equal-weights its long positions, initiating weights of target companies at 3%. The initial weight in short positions is between 0% and 3%, depending on the terms of the deal. MRGR charges 0.75%.
PerformanceLike many market-neutral strategies, a merger-arbitrage strategy should not be compared with broad market returns. Instead, a better way to think about a merger-arbitrage strategy is to compare it with the returns of cash (three-month T-bills) in the same period and to view it as a "cash-plus" strategy. Historically, as interest rates fall (rise), merger-arbitrage returns drop (increase). With interest rates near zero but expected to rise, a merger-arbitrage strategy that generates returns in excess of cash and fees could appeal to investors with heavy bond allocations.
Relative to cash, MNA has posted decent performance since inception, returning mid-single-digit returns over the trailing one-, three-, and five-year periods. CSMA has performed poorly, delivering negative returns in trailing one- and three-year periods and posting positive performance only this year. MRGR still is fairly new, but its returns have been in the middle of the other two offerings.
An Actively Managed OptionOne obvious alternative to the three ETPs is Merger (MERFX), an actively managed, open-end mutual fund that launched in 1989 and was the first mutual fund to employ a merger strategy. It has a Morningstar Analyst Rating of Silver. Merger Fund buys the stock of the acquisition target and then shorts the acquisitor's stock. In a cash deal, the fund's managers use options to hedge. One major difference between the $5.3 billion Merger Fund, which charges 1.23%, and the three merger-arbitrage ETPs discussed above is that Merger Fund is actively managed. As a result, while the three ETPs can be expected to hold all deals that fit their indexes' mandates--irrespective of the likelihood of them closing and the broader macroeconomic environment--the managers of Merger Fund have the freedom to pick and choose. Comanagers Roy Behren and Michael Shannon have put together an impressive record selecting the most attractive pending deals based on expected risk-adjusted return. They are unconstrained by position or sector limits (although individual deal exposures seldom exceed 5% of net assets) and have done an outstanding job delivering solid returns with minimal volatility (for example, Merger slid only 5.0% during the financial crisis, during the same period (Oct. 9, 2007, to March 9, 2009) that the S&P 500 cratered 54.9%.
Robert Goldsborough is an analyst covering equity strategies on Morningstar’s manager research team.
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