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.
“The goal of a merger arbitrage strategy is to provide more consistent returns and possibly deliver a smoother return path for investors. A merger arbitrage strategy can also serve as an important capital preservation tool and provide drawdown protection in tumultuous markets,” according to an IndexIQ research note.
The merger arbitrage strategy may also help diversify a traditional equity and fixed-income portfolio as this alternative investment has exhibited low correlation to traditional asset classes with a low standard deviation and beta as compared to other benchmark indices.
“An allocation to a merger arbitrage strategy can improve the risk/return profile of a traditional portfolio. The driver of returns for merger arbitrage strategies is isolated from broader markets, so the performance of such a strategy is not expected to be highly correlated to other asset classes over time. In addition, merger arbitrage strategies have significantly lower beta sensitivity to the broader market,” according to IndexIQ.
For more information on alternative strategies, visit our alternatives category.