Enormous transactions in media, food and health care are capturing the headlines. AT&T and DirecTV, Medtronic and Covidien, Actavis and Forest Labs each of these deals exceeds $40 billion. According to financial data provider Dealogic, year-to-date global merger and acquisition dollar volume puts 2014 in the top five of the past 20 years.
Its a bonus to own a stock that pops in price on a takeover offer. But is there a more systematic way to take advantage of these deals? Yes. Merger-arbitrage, a subcategory of the broader event-driven strategies category, can represent the most direct way to invest in mergers. Institutions have long used merger-arbitrage funds to diversify stock market risk. Annual returns are much less volatile than those in the overall markets.
The most common merger-arbitrage strategy involves buying the stocks of companies that have already been the subject of a takeover offer and shorting the stock of the acquiring company. Actively managed merger-arbitrage hedge funds do extensive research on both the acquirer and the target to determine how to position for each deal. Morningstar fund analyst Robert Goldsborough, who follows merger-arbitrage ETFs, finds merit in the strategy. Academic research shows that investors can enjoy attractive risk-adjusted returns from the spread between the offer and the market price in announced deals, he explains.
While most established merger-arbitrage funds target institutions or very high-net-worth individuals, the Merger Fund (MERFX), a mutual fund managed by Westchester Capital Funds and rated four stars by Morningstar, has $5.6 billion in assets with a $2,000 minimum investment and a 1.26% total expense ratio. Its published annual return over 10 years has been 3.43%.
SLOW BUT STEADY
You dont want to compare this strategy to stock market returns, says Goldsborough. You want to view these as cash plus as sort of an interesting bond alternative.
Indeed, while the 10-year return on MERFX has been less than the stock markets, comparing returns since 1999 favors the arbitrage strategy, showing similar appreciation with much lower volatility than the S&P 500. There are periods when this tortoise-like strategy outperforms the rambunctious hare. Could this be one of them?
Goldsborough wont commit, but he does see a favorable backdrop for the strategy in the current environment. More activity brings more attention and gives the funds more deals to choose from, he says.
HFR, a hedge fund database provider, reported that first quarter inflows into merger-arbitrage hedge funds was the highest since 2007 (see chart). Goldsborough points out that M&A is uncorrelated with other major asset classes. The second largest merger-arbitrage mutual fund, ARBFX, with $2.5 billion in assets, offered by the Arbitrage Funds, boasts a slightly negative correlation to the Barclays fixed income index and a very low .25 correlation to the S&P 500 over the past three years. You have to think about it from a volatility standpoint, reiterates Goldsborough. The biggest concern is that equity market valuations have gone up so it is more expensive to make acquisitions. Investors should note too the naturally high turnover in merger-arbitrage funds and resulting tax reporting and payments to the IRS. Most announced deals close in six to nine months. MERFX reports portfolio turnover of 240%.
ETFS GET IN THE GAME
If tax consequences are a concern, advisors can look to ETFs. The ETF structure allows for securities to be exchanged within the fund without a taxable event to holders. Merger-arbitrage ETFs have been slow to take off, but are gaining traction. Adam Patti, founder and CEO of IndexIQ, an alternatives ETF innovator, argues that merger-arbitrage represents fertile ground for rules-based indexing. The IQ Merger Arbitrage ETF, MNA, had $37 million in assets on July 18. Merger-arbitrage is very mechanical, Patti says. Its well-suited to a rules-based strategy.
IndexIQ looked at 10,000 announced deals over 10 years and evaluated what made a deal more likely to be successful and make a return for investors. MNAs rules-based index appears to effectively capture the bid-ask spread on deals; its annual return has been 2.5% since inception in 2009 after a 0.75% expense fee. This year through July 18, MNA is up 4.82%.
Performance variation between funds can result from differences in how positions are weighted, whether the fund hedges by shorting stock of acquirers or the overall market, the long/short ratio and other factors.
Several other strategies fall under the umbrella of event-driven investing. Hedge Fund Research collects performance data from 7,500 non-public funds. Under event-driven funds, it includes activist, credit arbitrage, distressed/restructuring, multi-strategy and special situations. New product is rapidly becoming available that extends these approaches to a wider marketplace. Guggenheim Investments Guggenheim Spin-off ETF (CSD) holds the stocks of 40 corporate spin-offs chosen by a pre-set indexed methodology. Newly independent and perhaps nimbler than funds that fall under a larger corporate umbrella, spin-offs have performed remarkably well. The $700 million CSD ETF has compounded at 28% in the five years through May 2014.
Fidelity Investments also has a new offer: Fidelity Event Driven Opportunities Fund (FARNX). Launched in mid-December 2013, it is up 9.47% through July 18. The $80 million fund, managed by Arvind Navaratnam, who has been at Fidelity since 2010, aims to own stock in companies that have been mispriced by the market.
Mispriced is the key word, Navaratnam says. We want to take advantage of corporate actions that result in mispricing of a security.
The fund, which has a 1.3% expense fee, does not pursue merger-arbitrage strategies. Our goal is to beat the market, he says. Merger-arbitrage tends to produce a narrow spread to cash over long periods of time. Also different from merger-arbitrage, FARNX expects to have longer holding periods for its investments, given Navaratnams three- to five-year investment horizon.
Navaratnams top two positions as of March 31 illustrate different types of event-driven opportunities. In the case of Tessera Technologies (TSRA), a $1.1 billion market cap company, he expects a restructuring to significantly improve earnings. For Murphy USA (MUSA), $2.2 billion market cap convenience store spin-off from Murphy Oil (MUR), he looks for the stock-incentivized management team to create long-term value for shareholders. Tessera remained the funds second biggest holding on June 30, while its largest on June 30, like Murphy, was a recent spin-off, Civeo (CVEO) from Oil States International (OIS).
This fund fits into Fidelitys larger strategy to offer more alternative or different methods where manager skill can add value, says Fidelity equity chief investment officer Joe DeSantis. We want to hunt down inefficiencies and opportunities in the market. Event-driven offers a dual value proposition, suggests DeSantis a lower correlation and the potential for alpha. It has a place in a broad array of portfolios.
But the question is, lower correlation to what? Because a portfolio manager can interpret an event in so many ways, the definition of event-driven is open to interpretation. Therefore, portfolio exposures vary widely. Fidelitys fund is presently exposed to small, mid-cap, less widely followed stocks so it is, in any case, unlikely to track the S&P 500. Ramius, a division of Cowen, launched the Ramius Event Driven Equity Fund (REDAX, REDIX) in October 2013. As of May 31, it was 29% invested in merger-arbitrage positions, with the remainder in activist and special situations. Its portfolio had little overlap with FARNX, underlining the importance of researching individual funds and their strategies.
Expect to see more offerings in this category from mutual fund companies. Event-driven is unlike merger-arbitrage in that it is not as easily amenable to programmed, rules-based strategies. Actively managed funds have the potential to add that elusive alpha that separates true investment skill from general market movements.
Shareholder and corporate activism have been working. Expect more of the same.