The recent spate of splashy corporate mergers and acquisitions deals point to a banner year in M&A activity—nearly $300 billion worth of deals have already been announced worldwide this year, according to Reuters. The last time M&A activity was this hot was in 2007, when roughly $3.5 trillion in deals were completed. 

Solid corporate fundamentals are a big reason for the uptick in 2013. “Many firms have large cash positions and there is still a lot of perceived value out there,” says Steve Sachs, head of capital markets at ProShare Advisors.

In addition, a number of deals are coming from private equity firms with wads of cash they need to put to work. According to Paris-based investment advisor Triago, private equity firms must spend more than $100 billion by the year-end or else redeem those funds back to their investors. These firms, along with other potential acquirers, also can borrow funds at rock-bottom interest rates.

In 2007, the gonzo M&A market led to a banner year for “merger arb” traders who capitalize on—or arbitrage—the spread between a proposed transaction price and the current trading price.

Alternative Assets

This time around, traders and investors can employ several exchange-traded products that have sprouted up to replicate the merger arb strategy. These exchange-traded funds and exchange-traded notes buy shares of the target company after an announcement, and often apply a hedge by shorting the purchaser or the market via index puts.

Merger arb funds tend to have a beta below 0.5, meaning they theoretically should move roughly half as much as the overall market as embodied by S&P 500 (which has a beta of 1).

As a result, these funds are less about delivering market-beating returns and more about delivering gains with a lot less market risk and volatility.

“Investors like to use the merger arb funds as part of a broader asset allocation strategy,” says Adam Patti, CEO of Index IQ, which launched the IQ Merger Arbitrage ETF (MNA) in late 2009. “They are included in the part of portfolios dedicated to alternative assets.”

These funds underperformed the broader market during the past few years when the pace of deal making was slow and their market hedging activity blunted the upside potential. For example, MNA has risen just a few percentage points since its inception more than three years ago.

But when Index IQ back tested the results of their methodology for the years 2003 through 2007, the data showed the S&P 500 rose 82 percent during that time versus a 76 percent gain for the hedged arbitrage strategy. But the merger arb approach also produced much lower volatility, so it handily outperformed the S&P 500 on a risk-adjusted basis. The fund’s top positions currently include Plains Exploration, NYSE Euronext and Nexen, all of which are trading ever closer to their buyout price.

Unshackling The Upside

The ProShares Merger ETF (MRGR) doesn’t place as strong an emphasis on hedging, doing so only when some or all of a company’s stock is used to buy another firm. As a result, its returns should be even more robust in a rising market than the Index IQ ETF. The ProShares fund was launched in December 2012, so there’s no track record to speak of. 

And whereas Index IQ actively selects which M&A transactions it seeks to arbitrage, the ProShares fund simply replicates the performance of the S&P Merger Arbitrage Index, which is comprised of a maximum of 40 large and liquid stocks that are active targets in pending merger deals—half of the targeted deals are in the U.S.

It’s best to view merger arb funds as a way to hedge a long-oriented portfolio. In effect these funds should produce greater gains than bonds but without the volatility of stocks. Indeed the S&P Merger Arbitrage Index has returned 4.6 percent on a 3-year annualized basis, which compares quite favorably to bond returns. The 5-year annualized return of 2.9 percent is less impressive.

But ProShares’ Sachs thinks the rising tide of deal making we’re now seeing should help boost results. “As the number of deals increases this approach will yield a rising number of profitable arbitrage opportunities,” he says. “More people will be looking at the merger arb angle as deal-making volume rises.”

Taking Note

While both of these ETFs charge a fairly stiff 0.75% expense ratio, Credit Suisse offers a pair of ETNs that carry a more reasonable 0.55% expense ratio. The Credit Suisse Merger Arbitrage Index ETN (CSMA) is based on a firm-run index that targets announced deals where the acquisition target has a market value of at least $500 million.

The rising tide of deal-making may lead investors to Credit Suisse’s sister fund, the Credit Suisse Leveraged Merger Arbitrage Index ETN (CSMB), which is a “2x” fund, which means it will move at twice the rate of the CSMA ETN.  Credit Suisse uses ETNs instead of ETFs because they’re better at avoiding the tracking error associated with some index-based ETFs.

Given the robust volume of deal making so far this year and what that portends for the rest of 2013, merger arb funds look poised to post solid gains with lower volatility.

 

David Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at TheStreet.com and research director at Individual Investor magazine.