A Big Deal: Merger-Arbitrage Funds Are Benefiting From Higher Cash Rates
Event-driven strategies have performed well in a difficult period for liquid alternatives, and rising cash rates could further boost their outlook.
Liquid alternatives that invest primarily in corporate activities stood out in a volatile 2018 with relatively strong performance, and higher cash rates improve their prospects. These event-driven strategies can invest in any corporate action event but are most commonly involved in merger arbitrage. While higher cash rates should boost total returns for any alternative strategy that uses derivatives and holds cash collateral, its effect on total return is more apparent for lower-volatility strategies like merger arbitrage.
Event-driven funds are a subset of the market-neutral Morningstar Category because they primarily invest long and short in equities. Morningstar currently classifies 20 of the 51 mutual funds in the market-neutral category as event-driven (Morningstar Direct users can see this by adding the institutional category data point to a workbook). In 2018, the median event-driven fund gained 1.15%, outpacing the market-neutral category median return of 0.62%; every other liquid alternative category lost money for the year.
The subgroup now has one of the best three-year track records among liquid alternatives strategies. Exhibit 1 shows performance, volatility, and diversification benefits for event-driven and liquid alternative strategies for the three years ended Dec. 31, 2018. Only the median options-based fund outperformed event-driven over the three-year period, but it did so with much higher volatility and a higher correlation to equities, diminishing its attractiveness as a diversifier.
The main driver of returns for merger arbitrage is the spread between the price at which company is set to be acquired and its price after the deal is announced. An acquisition target’s stock price typically gets a boost following the announcement, though its price usually doesn’t reach the agreed-upon acquisition price. This spread reflects the risk of the deal falling apart (the more skeptical market participants are, the larger the spread). If the deal closes, the event-driven fund earns that spread. If it fails to close, the downside is often much larger than the spread, emphasizing the importance of strong research and deal selection.
International Business Machines’ IBM recent announcement to acquire Red Hat RHT illustrates this. On Oct. 28, 2018, IBM announced plans to acquire Red Hat for $190 per share in a cash purchase. Red Hat’s share price jumped to around $170 the following day, a 45% increase from its prior close. The remaining $20 gap reflects uncertainty in the deal going through. If all goes as planned, as the deal moves closer to its expected completion in the second half of 2019, Red Hat should approach the close price of $190 a share. If the deal fails, it would likely trade closer to its pre-acquisition price of $116.
The above example illustrates a cash deal. When a company is purchased with stock, the fund manager takes a different approach, often buying the target and shorting the acquisitor to hedge against the stock price falling before the deal completes.
How Higher Cash Helps While the deal spread is the primary driver of returns, interest rates also play a role. Exhibit 3 shows the three-month Treasury bill return versus the 10-year break-even rate for inflation.
For the first time since early 2008, the three-month Treasury bill has a higher yield than the market’s expectations for inflation over the next 10 years. Even if the Federal Reserve doesn’t hike interest rates again in 2019, this still marks an improved interest-rate environment for event-driven funds. In addition to earning interest that outpaces inflation on cash held as collateral for short positions, the higher cash rates should also lead to wider deal spreads as higher rates cause investors to demand bigger spreads in order to take on the risk of a deal not going through.
The last period that cash rates yielded more than the rate of inflation lasted approximately three years, from February 2005 to February 2008. Hedge fund strategies as a whole excelled during this time period, but event-driven strategies stood out. With that in mind, the current short rates are not at the levels seen during this period, when cash could return upwards of 5%. So, while the return prospects look better compared with the recent past, the Fed would need to take significant steps to match the levels of 2005 to early 2008.
Morningstar's Top Event-Driven Strategies Even with a more favorable environment for event-driven funds, manager selection remains crucial. In 2018, returns for event-driven funds ranged from negative 17% to 8%. As stated earlier, the downside risk of a deal breaking is typically much larger than the spread a fund can earn when a deal closes. July 2014 through September 2015, for example, was a particularly difficult period for these strategies. Broken megadeals like T-Mobile/Sprint, Shire/AbbVie, and Mylan/Teva created a minefield for deal-pickers. The average event-driven fund lost 1.2% in this period, with merger-arbitrage funds hit particularly hard. Event-driven funds benefited from a competitive landscape for mergers in 2018. The bidding war between Comcast CMCSA and Twenty-First Century Fox FOXA for European media company Sky PLC, for example, led to one of the best opportunities for merger arbitrage during the year. Comcast's winning bid of $22.50 per share in September 2018 was 38% higher than its first counterbid for the company in April 2018. Looking to 2019, one popular school of thought is that slowing economic growth may lead to more mergers and corporate engineering like spin-offs as companies look for ways to boost earnings. JPMorgan, Goldman Sachs, and the International Monetary Fund are among those that think growth will moderate this year.
Below are our five best picks for event-driven strategies. All of these them currently carry Morningstar Analyst Ratings of Bronze. Although the median event-driven fund lagged cash during 2018, four of our five Medalists outperformed the median and cash in 2018.
AQR Diversified Arbitrage ADAIX invests in arbitrage-related strategies that often involve a liquidity premium. Managers Mark Mitchell and Todd Pulvino manage this offering, which splits exposure across merger-arbitrage, convertible-arbitrage, and event-driven strategies that include closed-end fund arbitrage and spin-off arbitrage, among others. Its beta exposure to equity markets is near zero, and its respectable 2.12% return in 2018 came with hardly any volatility.
A seasoned management team leads Arbitrage Fund ARBFX; lead manager John Orrico has been investing in merger-arbitrage deals since 1994. The team's focus on managing downside risk has limited large drawdowns since its inception in 2000; its maximum drawdown was just 6.3% in 2008. During the most recent U.S. equity market drawdown from Sept. 21, 2018, through Dec. 24, 2018, it gained 1.56% while the Morningstar U.S. Markets Index lost more than 19%.
BlackRock Event Driven Equity BILPX invests across all corporate events including mergers, leadership changes, spin-offs, and arbitrage opportunities across a firm's capital structure. BlackRock's scale provides opportunities to meet with executives driving the deals, as well as large in-house research and legal teams. Its strategy and staff were overhauled in May 2015, before which it took a long-only approach whose results should be ignored. Since then, it has returned 4.89% annually, topping all event-driven peers.
Merger Fund MERFX has invested in merger-arbitrage strategies since its 1989 inception. Its edge comes from an investment process that leverages a combination of legal, investment banking, and equity derivatives expertise to assess deal risks. It has returned 6.11% a year over its 30-year history, with a low 0.15 beta to the S&P 500.
Management of Touchstone Merger Arbitrage TMGLX generally steers clear of hostile takeovers, leveraged buyout transactions, and rumored deals, which helped it avoid large broken deals. Andrew Bail recently joined this strategy as a manager, and he uses derivatives expertise from his time at JPMorgan to structure shorter-duration trades that resemble the merger-arbitrage risk/reward profile. It stumbled a bit in 2018, but its 1.77% loss still topped equity market indexes.