This year has seen a spate of major announcements regarding mergers and acquisitions, including AT&T’s proposed deal to buy Time Warner, TD Ameritrade’s announced purchase of Scottrade, and Monsanto and Bayer seeking to join forces, among others.
In fact, the past few years have seen a flurry of consolidation, with a record $5 trillion worth of deals done in 2015, which was one-third more than was completed in 2014, according to research analysts at Third Way.
Slower economic growth, cheap money and tax arbitrage are just some of the reasons behind the wave of activity. For investors seeking to capitalize on merger arbitrage, there are two exchange-traded funds to look at.
The IQ Merger Arbitrage ETF (MNA) and ProShares Merger ETF (MRGR) take positions in publicly announced mergers and are designed to act as a hedge against the broader market. The IQ Merger Arbitrage ETF is the older and larger of the two, having launched in 2009 and with roughly $134 million in assets under management. The ProShares Merger ETF launched in 2012 and has $5.4 million in AUM. Both have expense ratios of 75 basis points. An exchange-traded note, the Credit Suisse X-Links Merger Arbitrage ETN (CSMA), closed earlier this year.
Both MNA and MRGR are similarly constructed. Both funds invest in companies after the deals are announced, rather than speculating on potential deals. The funds seek to profit from the price difference between a target company’s stock price after a deal is announced and the price an acquiring company will pay for it, known as the spread.
When a deal is announced, the target company’s share price will eventually rise toward the deal price until the transaction closes. Adam Patti, chief executive officer of IndexIQ, says the best outcome for a merger is if there is more than one interested party in the target company and the deal price rises, while the worst outcome is if a deal falls through and the target company’s price falls.
The MNA fund tracks the Merger Arbitrage Index, which was created by IndexIQ. The company looked at 10,000 merger arbitrage transactions and found clear trends. To construct the index, it excludes deals that were low-balled, which tend to do poorly for investors, and avoids deals that go for less than a controlling stake.
Deals are weighted based on trading volume. Once a deal is announced, they look at trading volume for the 30 days prior to get a sense of liquidity. The higher the volume, the greater the weight in the index, Patti says.
Because the index is rebalanced monthly, there’s on average a two-week lag from when a deal is announced and its appearance in the index. Right now, the largest equity holding is LinkedIn (9.67 percent), St. Jude Medical (7.59 percent) and Rackspace Holding (6.34 percent).
He adds that the ETF has a significant cash holding at 9.5 percent, which is collateral for the fund’s short position, which is the other strategy MNA pursues. To offset purchases, it sells against the stock’s index sector. In the case of deals involving international entities, it sells against the region. Using the AT&T news as an example, the fund would sell the S&P telecommunications sector, he says.