Favorable conditions are in place for merger-arbitrage ETFs, including increasing M&A activity and the likelihood of higher interest rates.
This week began with a flurry of merger-and-acquisition activity. While global M&A activity hit a three-year low in the first half of 2013, U.S. deal activity has been up nicely for the year to date (up 34%) relative to 2012. Some of the biggest deals have been Berkshire Hathaway's BRK.A acquisition of H.J. Heinz, Anheuser-Busch Inbev BUD acquiring Grupo Modelo, the merger of T-Mobile US TMUS and MetroPCS, and Comcast CMCSA acquiring from General Electric GE the balance of NBC Universal that it didn't already own. Plenty of other major deals are pending, including Dell's DELL proposed leveraged buyout, Office Depot's ODP bid to acquire OfficeMax OMX in what's being termed a merger of equals, the merger of US Airways LCC and American Airlines parent AMR, and Linn Energy's LINE proposed buyout of Berry Petroleum BRY.
Now, the three newly announced deals this week--Omnicom OMC and Publicis Groupe coming together in a $35 billion merger-of-equals pairing, drugmaker Perrigo PRGO acquiring biotech firm Elan ELN for $8.6 billion, and Canadian retailer Hudson's Bay HBC buying retailer Saks SKS for $2.4 billion--suggest that not only is U.S. M&A activity remaining strong but that global deal activity also may be picking up. Indeed, in all three of this week's headline deals, at least one partner is a foreign company. While the biggest headwind to further deals may be rich stock market valuations at present for potential acquisition targets, strong equity markets and historically low debt costs are continuing to create very favorable conditions for more deals. Also, corporate balance sheets remain flush with cash and plenty of private equity firms are now reaching their exit points for the flurry of buyouts that occurred in the 2005-08 time frame.
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. Academic research has concluded that investors can enjoy attractive, risk-adjusted returns from merger-arbitrage strategies. What's more, 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 Hood
Merger-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 merger-arbitrage strategies have been used for many years by institutional investors, 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 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.
Another merger-arbitrage ETP is IQ Merger Arbitrage ETF MNA, which launched in 2009 and tracks an Index IQ-managed basket of announced takeover targets and then shorts the global market. Unlike CSMA, MNA includes global deals, which is why the fund holds a company like Germany cable giant Kabel Deutschland, which U.K. telecom firm Vodafone VOD recently announced plans to acquire. CSMA charges 0.76%.
Still another option is the recently launched 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, which rolled out in December, charges 0.75%.