Investors looking to hedge against inflation should consider adding a merger arbitrage strategy to their portfolios.
The most recent gauge on inflation showed that the consumer price index for all items rose 0.6% in January, driving up annual inflation by 7.5%. Geopolitical tensions in Russia and Ukraine have heightened fears that inflation could reach double digits in the near future.
The price of oil is already at an eight-year high, and while it’s not yet clear how material of an impact a broader Russian incursion into Ukraine would have on crude prices, analysts have predicted it will pull them higher.
Surging crude oil prices would have a global impact. Economists have predicted that higher prices for motor fuel, heating oil, and natural gas for American consumers could push inflation into double digits and raise expectations of high prices for months and years to come.
During periods of inflation, merger arbitrage index returns have historically fared well because higher inflation tends to lead to higher rates, and higher rates tend to increase the merger arbitrage spread.
Making It MERFX
The Merger Fund (MERFX), managed by Virtus affiliate Westchester Capital Management, the first mutual fund devoted exclusively to merger arbitrage, has historically outperformed bonds in rising rate environments.
The Bloomberg U.S. Aggregate Bond Index has had 28 negative quarters since the inception of MERFX in 1989. 96% of the time, the fund (at NAV) outperformed the Bloomberg U.S. Aggregate Bond Index, according to data from Morningstar and Westchester.
There have been three periods in the last decade where this trend can be observed.
During the segment between August 2020 and September 2021, MERFX’s annualized returns were 2.82%, compared to taxable and tax-exempt bonds, which saw annualized returns of -0.66% and 1.57%, respectively, according to Morningstar and Westchester.
From June 2016 through the end of 2018, MERFX saw 4.75% in annualized returns, compared to taxable and tax-exempt bonds, which saw annualized returns of 0.37% and 0.92%, respectively, according to Morningstar and Westchester.
During July 2012 through the end of 2013, MERFX saw annualized returns of 4.04%, compared to taxable and tax-exempt bonds’ annualized returns of -0.17% and 0.81%, respectively, according to Morningstar and Westchester.
The same trend is observed in previous periods of rising rates, including August 2010 through March 2011, December 2008 through March 2010, and many others in earlier decades.
MERFX also offers the benefit of diversification. Deal risk is modestly to negatively correlated to conventional asset classes, so adding a merger arbitrage strategy to a portfolio may diversify risk in a turbulent market.
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