Merger & acquisition activity recently hit a seven-year high, with global deal value topping $1 trillion at the end of the second quarter, according to various news reports. Big transactions have generally led the way, though there are signs that activity is picking up in the middle market as well.
The factors driving this current activity are the same ones that have been cited for awhile – low interest rates, high levels of cash on corporate balance sheets, and a slow growth economic environment which is leading companies to seek new revenues and market opportunities through strategic combinations.
As an investor, it’s hard not to notice when a deal is announced and the stock of the target company jumps. But trying to determine in advance which companies are most likely to be acquired at a premium is like trying to catch lightning in a bottle. As an investment strategy, this is almost certain to end badly.
But there are other ways to go about participating in the current takeover wave. For example, merger arbitrage strategies seek to exploit the difference between the announced purchase price for an acquisition and the current trading price, recognizing that the target company will often trade at a discount, a circumstance that reflects in part uncertainty as to whether or not a deal will get done. While the returns form this approach may be less dramatic than correctly guessing a future takeover candidate, they are likely to be more predictable. The IQ Merger Arbitrage ETF (NYSE Arca: MNA) is an exchange-traded fund (ETF) that pursues this strategy.
Typically, merger arbitrage funds (both hedge funds and mutual funds) use fundamental analysis to select the deals in which they participate. But it is also possible to build a strategy around a rules-based approach, investing in a broad range of announced deals at month’s end and refreshing that list every month.
Our research shows that the universe of target companies creates positive excess returns relative to the equity markets and that owning a broad cross section of deals exposes the portfolio to the positive excess returns. Further, employing some simple mechanical screens can improve the positive excess returns. Our work also demonstrates that although there is some degradation in performance by employing a mechanical approach at the end of each month as opposed to daily, the positive excess returns from a monthly rebalance are still significant.
Finally, we show that a mechanical implementation of a strategy that invests in a broad range of announced deals can deliver positive excess returns with an attractive return to risk ratio. The strategy can be enhanced through hedging which can be accomplished either by short exposure to the broad market or by going short in the acquirer names. Both methods can improve the return to risk ratio by lowering the volatility of the portfolio but also lower the return of the portfolio.
As of July 8, 2014, MNA held approximately 50 companies that were targeted to be acquired. This included many high profile deals, including some recently announced acquisitions by Level 3, Oracle and SanDisk. Based on our rules-based methodology, this list will continue to be update monthly, with new announced deals added and completed transactions rolling off. In this way, MNA will offer investors a dynamic portfolio, and a compelling broad-based vehicle for participating in an M&A boom that shows every sign of continuing for some while.
This article was written by Adam Patti, chief executive officer of IndexIQ, which sponsors the IQ Merger Arbitrage ETF (MNA).