A Look at Merger-Arbitrage ETPs

A version of this article appeared on July 31, 2013.

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

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 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 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

Another option is an exchange-traded note issued by

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%.

Performance Like 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 Option

One obvious alternative to the three ETPs is

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