U.S. equities are hitting record highs in an extended bull market, but valuations have grown pricey and may be susceptible to sudden risk-off events. Nevertheless, exchange traded fund investors may consider alternative investments like a merger arbitrage strategy to smooth out the ride in a bumpy environment.
For those interested in the M&A strategy, the Index IQ Merger Arbitrage ETF (NYSEArca: MNA) provides investors with a diversified approach to a group of takeover targets. The ETF employs a type of alternative, “directional hedge fund strategy” called merger arbitrage. The fund would capture the spread or difference between a stock’s trading price before a deal is announced and its eventual takeover price.
In many cases, the shares of the target company will trade at a discount to a proposed price. This may be due to a number of factors, including concern over the buyer’s ability to fund the deal, the possibility of regulatory or anti-trust challenges delaying or blocking the deal, or stock price fluctuations in a stock-for-stock transaction, among others. This gap, though, tends to shrink as the closing date nears, and disappears when the deal is done. In the meantime, the merger arbitrage investor can capture the return generated as the offer price and closing price come together, a relatively low-risk way of participating in M&A activity.
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A merger arbitrage investment strategy may help investors garner more consistent returns and possibly deliver a smoother ride, serving as an important capital preservation tool and providing drawdown protection in times of volatile market conditions.