Investors are picking themselves up in 2019 after a tumultuous way to end the 2018 year. After all was said and done, the Dow Jones Industrial Average fell 3.5 percent, while the S&P 500 was down 4.4 percent and the Nasdaq Composite declined 2.8 percent.
2018 marked the worst year for stocks since 2008 and only the second year the Dow and S&P 500 fell in the past decade. In 2019, investors are no doubt reassessing their strategies for how to distribute their capital through the rest of the year, including alternative strategies that can provide uncorrelated returns with the movement of U.S. equities.
Capitalizing on Deal Spread
One such area investors may not be familiar with include merger arbitrage strategies.
“Alternative investments, specifically merger arbitrage strategies, are designed to provide some protection in times like these while allowing investors to maintain exposure to the market,” wrote Salvatore Bruno, Chief Investment Officer of IndexIQ.
The impetus for incorporating a merger arbitrage strategy is using event-driven news to capitalize on pricing differences between the current trading price of a recently announced merger or acquisition target and the target price. The target’s stock price is typically impervious to the fluctuations of the market from the time an acquisition deal is announced up to when the actual deal closes.
“For example, ABC company announces its intent to acquire XYZ company for $100 a share,” wrote Bruno. “Prior to the news, XYZ is trading at $90 and subject to typical market activity; post-news, its shares jump to $99, still a dollar short of the offer price. The reason for this spread, or difference in share prices, is the risk of deal failure, or the chance that the deal won’t go through for one reason or another.”
“Once the deal is announced, the acquisition target is usually less subject to the movements of the market, potentially creating a smoother source of returns,” Bruno added. “When the deal does close at $100 a share, the arbitrage, or potential gain, is $1 a share.”
Bruno also notes that while arbitrage opportunities exist regardless of the construction of the deal, deals including cash can provide further insulation from market fluctuations, which have become more prevalent in recent years.
Merger Arbitrage Strategy in an ETF Wrapper
In order to take advantage of the deal spread as well as to reduce risk of a merger deal falling through, the strategy invests in multiple deals that are scattered through various phases of the deal cycle. In the past, such a strategy has only been made available for investors of high net worth, but it is now being replicated in an ETF wrapper for all investors via the IQ Merger Arbitrage ETF (NYSEArca: MNA).
In 2018, mergers and acquisitions were abound in various sectors as the historic bull market in U.S. equities saw a serendipitous rise in such activity, particularly from the technology sector that fueled much of the growth. Notable activity came from the likes of tech giants, such as Hewlett-Packard Enterprise, Cisco Systems, Accenture, Cisco Systems, AT&T, and Sprint.
However, mergers and acquisitions have been seen across a variety of sectors, which has helped MNA. MNA seeks investment results that correspond generally to the price and yield performance of its underlying index, the IQ Merger Arbitrage Index, which seeks to employ a systematic investment process designed to identify opportunities in companies whose equity securities trade in developed markets, including the U.S., and which are involved in announced mergers, acquisitions and other buyout-related transactions.
Performance of merger arbitrage strategies historically has been uncorrelated to other core asset classes, providing a potential source for downside risk mitigation. Merger arbitrage returns are tied to the interest rate cycle, as the risk-free rate is an inherent part of the deal spread. Merger arbitrage strategies may also be a potential dampener for stock market volatility; on days when the S&P 500 fell 1% or more in the current economic cycle, M&A strategies did not decline as much and in many cases provided positive returns.
MNA has historically provided risk mitigation
Days where the S&P 500 Index dropped at least 1%
Source: Morningstar. Analysis run: 12/31/13-12/31/18. Pas performance is not indicative of future results. An investment cannot be made in an index. Click on the fund name for the most current fund performance.
As of 12/31/18
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The IQ Merger Arbitrage Index seeks to achieve capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer.
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