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An Introduction To Merger Arbitrage And Available ETF Options

Summary Everyone is fascinated by Merger Arbitrage. This is an introduction. You have a few options ETF wise. Find out why I don’t like them. I recently discussed gaining exposure to spinoffs through an ETF. If gaining exposure to such deals passively is a good idea, one might ask whether other “Hedge fund strategies” can be attained through ETFs. We’ve all heard of famous billionaire arbs such as John Paulson (although he didn’t make his billions with merger arbitrage), and we might be tempted to have a go at such strategies. In this article I will: Go over the basics of merger arbitrage for readers who are not familiar with the practice. (If that’s not you, skip below.) Highlight the main risks linked to the strategy. Take a look at two Merger ETFs and the construction of their underlying indexes. Explain why I don’t think such ETFs make a good addition to your portfolio. THE BASICS Merger arbitrage attempts to profit from merger activity through spreads between offer price and trading price. Here is a simple example which expresses the strategy. Company A is trading at $10 a share. Company B is trading at $20 a share. Company B offers to buy company A, offering owners one share of Company B for each share of Company A. Following the announcement company A’s stock surges to $15. If the deal goes through, owners of Company A will have a security which is worth $20 today. To lock in the $5 spread between current price and offer, investors can go long A, and Short B; simultaneously buying the same asset for $15 and selling it for $20. Why would a security trade for $15 if someone is going to pay you $20 for it, and how do we interpret this? For a number of reasons, which we will discuss further, the deal might not go through. In such a case, the target’s (Company A) stock will usually fall back to pre-merger announcement prices ($10 in our example). Therefore the price at which a security a security trades between the acquisition’s announcement and its completion reflects the odds the market assigns to a deals completion. The basic math is: [(Current Price)-(Price before deal announcement)] / [(Offer Price)-(Price before deal announcement)] In the case of our example: (15-10)/(20-10)=50% As a deal gets closer to going through, you can expect the spread between security A and B to diminish. Whether A goes up, B goes down, or they meet somewhere in the middle, going long A and short B would net a profit as both prices converge. Since deals can go south for a number of reasons, investors must determine when the odds the market gives any given deal don’t match their own estimation of the odds. If an investor believes our deal has a 70% chance of being completed, the trade would seem attractively priced today (70%> 50%) and he could take a long position in A and a short position in B. Likewise if an investor believes our deal has only a 30% chance of being completed, he might view today’s price as expensive, and decide to go short A and long B, on the basis that the spread could get wider. Since large initial increases in shares of the target firm occur after the announcement, the downside if the deal doesn’t go through is usually larger than the possible gain (the spread). So there you have it. This traditional strategy is mostly used in the case of a stock for stock offer. In the case of a cash only offer, shorting the acquirer will be of no use in capturing the spread. THE RISKS While being a risk arbitrageur seems like an interesting strategy since your simultaneous long and short positions reduces your systematic exposure, many things can go wrong. The returns are mostly deal driven, so risks come primarily from regulation and financing issues. Even if most mergers are allowed by regulators, it is imperative to assess antitrust concerns before regulators rule. In deals where antitrust issues are a primary concern it is likely the spread will narrow shortly after the deal has been approved by regulators. There is no free lunch here, investors must do their own research and due diligence to assess how these issues can impact the deal’s timing and viability. Regulators being fun as always, might also cancel the deal for many other reasons, such as nationalistic concerns. Also if part of the deal involves a cash transaction, financing issues must be taken into account. Which Banks are working with both companies? Is financing secured, or likely to be? Merger Arbitrage returns are negatively skewed. If deals go through, small consistent gains are made, but investors are exposed to large losses when they run in to problems. In other words, large upswings occur a lot less than large downswings, distributing the returns somewhat as such. So as I mentioned above, the real opportunity lies in detecting deals where the probabilities of a deal going through are significantly different than what the market price implies. On Seeking Alpha, Chris Demuth does a great job at getting all the M&A info and ideas you need. But we do both agree on one point, Merger Arbitrage is research intensive. MERGER ETFS Given the extensive research required, you might be tempted to gain exposure to merger arbitrage plays through ETFs. Here is a brief overview of two of them, the IQ ARB Merger Arbitrage ETF (NYSEARCA: MNA ) and the Proshares Merger ETF (BATS: MRGR ). The IQ Merger Arbitrage ETF tracks the IQ Merger Arbitrage index which is a rule based index which seeks to gain exposure to companies all over the world in which a merger or acquisition announcement has been made. The index is rebalanced monthly, and excludes deals which have an offer price inferior to the price of the stock prior to the announcement. If the implied probability of completion is less than zero or greater than 100%, the positions will be held until the deal completes or 180 days pass after the announcement. When an implied probability is between 0 and 100, existing positions will be held for up to 360 days. Here are a few key points to keep in mind: Long positions in the target only Equity Hedge achieved through shorting sector or regional ETFs Cash exposure is kept in short term treasuries. No qualitative assessment of individual deals. No stock can be above 10% of the index. MNA data by YCharts The Proshares Merger ETF tracks the S&P Merger Arbitrage index. A maximum of 40 long positions and 40 short positions are included in the index at any given time. Deals are subject to liquidity and sizing constraints (Must be bigger than $500 mi). Everyday, if a new merger is announced, the position is added to the index. If there are already 40 positions, the position with the weakest performance since inclusion in the index is removed and is replaced with the new one. A few things to remember: Long and short positions in individual stocks are taken, unlike MNA. When included into the index, positions are sized at 3%. Like MNA this is a rule based index with no qualitative analysis. SPY data by YCharts MY TAKE ON THESE. MNA data by YCharts Let’s start with what is to be liked. Both ETFs are diversified and give exposure to a bunch of deals worldwide. Over the last 3 years, we can say that MNA has achieved its objective of attaining consistent absolute returns with little correlation to traditional equity markets. On the other hand MRGR has produced negative returns overall. And I believe this underperformance -as in less than 0%- is due to a structural problem in the Index’s construction. If 40 positions already exist when a new deal arrives, the deal with the worst performance is excluded. This defies the underlying logic if capturing the spread in the current price and offer price: To capture it, you hold until completion or until completion is totally priced in! As such MRGR might be discarding the most lucrative deals because of a structural flaw. MNA has its own flaws. By using ETFs as a hedge, you are partially removing market risk, but not locking in a spread between a target and an acquirer. In the case of an all stock offer, if the acquirers price was to converge towards the targets price rather than the other way round, you wouldn’t profit. But my main problem re$mains the ignorance of risks. Successful M&A investing revolves around finding mispriced deals to go long or short. In both of these indexes you don’t account for the annualised return which is possible, and you don’t stack it up against the risks. CONCLUSION As such I chose to not invest in either of these ETFs. If I had to chose, I would pick MNA, although I am not a fan of its structure, it is less harsh than that of MRGR. Target companies tend to depend on event risk more than market risk, so shorting out market exposure does allow for exposure to M&A deals, even though it doesn’t do so in an ideal manner. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Special Events ETFs – Not What You Think

Summary Special events are investing can significantly increase the portfolio return. Many investors interested in the returns of special events investing don’t want to trade these events actively. Here is why ETFs following special events indexes are not a good enough substitution. It is widely accepted that special situations investing can drive higher returns in the long run than a simple long-only investing methodology. For most investors engaging in merger arbitrage, spin-off and IPOs require too much time and effort, so they prefer to use ETFs to mimic this kind of investing. The rationale is easy to articulate in these cases: M&A, spin-offs, and IPOs were extremely successful strategies to many funds, so I, as a common investor, could copy their moves by investing in these ETFs. Well, not exactly. M&A Focused ETFs In the merger arbitrage area, there are three ETFs trying to generate excess return by engaging in merger arbitrage strategy; however, as shown in the table below, all three ETFs generated inferior performance compared to the popular SPDR S&P 500 ETF (NYSEARCA: SPY ) in every period. Symbol Name 3M 6M YTD 1Y 2Y 5Y SPY SPDR S&P 500 ETF -1.75% 1.61% 1.16% 7.29% 22.80% 92% MNA IQ Merger Arbitrage ETF -2.56% -0.53% 1.11% 3.52% 6.93% 9.98% CSMA Credit Suisse X-Links Merger Arbtrg ETN -1.97% 0.15% -0.21% -2.95% -6.72% -3.09% MRGR ProShares Merger -0.84% -0.19% 0.91% -0.16% -3.35% -8.38% Source: Table constructed by Finro based on information from Yahoo Finance The largest fund and best-performing ETF in the merger arbitrage focused ETFs is MNA, the IQ Merger Arbitrage ETF that generated only ~10% return over the last 5 years which is extremely lower than SPY’s 92%. The chart below illustrates it best as the three M&A ETFs are mostly flat over the last five years while SPY climbs. Does it mean that investors should not engage in merger arbitrage strategies to generate an excess return from special situations? Of course not, however, the passive investment offered by these ETFs probably does not fit the merger arbitrage investment strategy profile. Active funds and managers who use this approach can pick and choose the deals they want to engage in and how much funding to allocate to each deal. However, ETFs (and ETNs) are required to follow a particular index in a passive investment methodology that is probably hard to fit a merger arbitrage strategy into. This is presented best in Chart 2 below, which shows the inherent problem with merger arbitrage ETFs – the indexes they follow don’t offer any added value over the S&P 500. In this example, the Credit Suisse Merger Arbitrage Liquid Index is relatively flat from Dec-09 while S&P is a bit more volatile, but it drives more than a 90 percent return on the same period. Spin-Off and IPO-Focused ETFs The other two areas mentioned at the beginning, spin-offs and IPOs, present a different story. IPO and Spin-Off ETFs invest in long-only positions in the stock of companies that have recently gone public or spun off from parent companies. These strategies are a better fit in a passive investment methodology that is a simple long in most cases. As shown in the table below, the two IPO ETFs differ in performance. While First Trust US IPO ETF (NYSEARCA: FPX ) beat SPY in most time periods chosen, the Renaissance IPO ETF (NYSEARCA: IPO ) offers inferior returns in most periods. The Guggenheim Spin-Off ETF (NYSEARCA: CSD ) provides exposure to the vibrant spin-off sector that has been very popular lately, but it also suffers from slightly inferior returns compared to SPY in the shorter periods studied. Symbol Name 3M 6M YTD 1Y 2Y 5Y SPY SPDR S&P 500 ETF -1.75% 1.61% 1.16% 7.29% 22.80% 92% IPO Renaissance IPO ETF 1.20% 0.22% 1.75% 4.36% 14.16% N/A FPX First Trust US IPO ETF -4.88% 9.50% 9.31% 15.51% 31.04% 179.90% CSD Guggenheim Spin-Off ETF -6.90% -4.06% -2.41% -1.62% 11.42% 130% Source: Table constructed by Finro based on information from Yahoo Finance Market Vectors Global Spin-Off ETF (NYSEARCA: SPUN ), a new Spin-Off ETF, started trading in June. It has generated a slightly better return since its inception than CSD in the same time period: -6.7% and -7.3%, respectively. Final Thoughts Special events investing is a tremendous way to achieve an excess return for a portfolio by monetizing mergers and acquisitions, spin-offs or IPOs. There are some ETFs following indexes of merger arbitrage, spin-offs or IPOs. However, most of them do not outperform SPY, and that is a huge disadvantage. While I firmly believe every investor should allocate some of his or her portfolios to special events investing, I think, as presented above, that active investment strategies like those require active investment decisions. Except FPX and IPO investing, engaging in active investment strategies through passive investment vehicles just doesn’t work – to monetize these events, investors should actively invest in them selectively. The FPX holds the top-ranked 100 newly traded companies for the first 1,000 days on the market – which is a more simple methodology to follow through an ETF than the other strategies. Investors can use the FPX for an IPO exposure without the need to actively trade these events. Other than this particular example, I believe investors should trade actively when trying to engage in active strategies like M&As and spin-offs. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The information provided in this article is for informational purposes only and should not be regarded as investment advice or a recommendation regarding any particular security or course of action. This information is the writer’s opinion about the companies mentioned in the article. Investors should conduct their due diligence and consult with a registered financial adviser before making any investment decision. Lior Ronen and Finro are not registered financial advisers and shall not have any liability for any damages of any kind whatsoever relating to this material. By accepting this material, you acknowledge, understand and accept the foregoing.

The Season For Merger Arbitrage

Summary The ongoing boom in M&A activity is creating a more robust opportunity set in merger arbitrage. Importantly, this is occurring at the same time that most other strategies (and general equity market exposure) are becoming increasing overvalued/unattractive. From a risk standpoint, merger arbitrage also appears to be becoming more compelling given its relatively low beta, and the plethora of risks building for general equity market exposure. A Little Background For those new to the strategy, generally when a merger is announced, the stock price of the target immediately jumps toward (but not fully to) the offer price. The remaining gap exists for two primary reasons: 1) there is a possibility (typically small) that the deal could fail to be consummated, and 2) legacy holders of the target’s stock that have typically just experienced a large windfall gain are sometimes willing to forgo the relatively smaller amount of remaining alpha due to their lack of experience in merger arb (and consequent limited ability to underwrite the risks). Merger arbitrage specialists attempt to capture this alpha by buying the target’s stock (and shorting the acquirer’s in cases where part of the consideration offered is stock). They then seek to profit as the spread compresses, with the deal moving to completion. Merger arb is most commonly pursued by hedge funds. However, in recent years ETFs have also emerged to pursue the strategy passively (the largest of which being the IQ Merger Arbitrage ETF (NYSEARCA: MNA )), and there are a handful of Seeking Alpha contributors focusing on it as well. Increasingly Attractive when Other Strategies are Least Attractive Like most strategies, the general attractiveness of merger arb varies over time based on fluctuations in supply (in this case of M&A deal volume) and demand. As mentioned, demand comes mostly from hedge funds and tends to be reasonably sticky, as it takes time for the funds to raise capital from their underlying investors (or for investors to take back capital) based on changes in the attractiveness of the opportunity set. The result is that when there are big changes in deal volume, this supply can temporarily overwhelm (or underwhelm) demand, leading to higher (or lower) risk-adjusted returns. From 2010 through 2013, deal-flow was limited as corporate managements were reluctant to make bold moves toward expansion with fresh memories of the 2008-2009 disaster in mind. As a result, merger arb players struggled to perform, and the HFR merger arb index posted very modest single-digit returns annually. However, since 2014 there has been a substantial pick-up in M&A activity as the financial crisis has fallen farther from mind, many corporate balance sheets have become increasingly bloated with cash, and tightened credit spreads have enabled companies to raise capital very cheaply. (click to enlarge) Source: Dealogic Though many hedge funds have been seeking to deploy additional capital in the space, demand has still been slow to catch up with supply. The result is that merger arb has been becoming more interesting at the same time that most other strategies and equity beta have become less attractive. One illustrative data point is that the number of $100m+ deals with annualized spreads over 15% ballooned from late 2014 to now, as shown below. Source: SINLetter Less Beta when Beta is Most Overvalued In the current environment with high equity valuations and abundant macro dangers, another potential attraction of merger arb is its risk profile, as noted above. For each deal, the main sources of risk are idiosyncratic/company-specific (e.g., antitrust investigations, unwieldy regulatory reviews, loss of financing). It is true that merger arb still retains some exposure to general risk premiums, or the tendency of market participants to require higher returns to hold any investments during times of fear. Further, the probability of deals breaking does increase somewhat when market is stressed, particularly for deals with financing contingencies (e.g., LBOs). However, the recent M&A boom has predominately represented strategic deals with relatively few LBOs. Also, the level of exposure to general risk premiums is lessened due to the short duration, self-realizing nature of the strategy. Accordingly, the strategy has tended to produce much lower drawdowns than the overall equity market during past market shocks. For instance, in 2008-2009, the CSFB risk arbitrage index posted a maximum drawdown of roughly 20% vs. roughly 50% for the S&P 500. In 2000-2001, the risk arb index posted a max drawdown under 10% vs. ~40% for the S&P 500. Conclusion For those with interest/experience in event-driven investing, this is a good time in the cycle to explore opportunities in merger arb. For those with less experience or time to underwrite the risks of individual deals, a diversified approach may be worthy of consideration, for instance through one of the ETFs that exist today. Disclosure: I am/we are long DTV, MEA, OVTI, OWW, DARA, PNK, ODP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.