By Robert Goldsborough
This week began with a flurry of merger-and-acquisition activity. While global M&A activity hit a three-year low in the first half of 2013, U.S. deal activity has been up nicely for the year to date (up 34%) relative to 2012. Some of the biggest deals have been Berkshire Hathaway's (BRK.A) acquisition of H.J. Heinz, Anheuser-Busch Inbev (BUD) acquiring Grupo Modelo, the merger of T-Mobile US (TMUS) and MetroPCS, and Comcast (CMCSA) acquiring from General Electric (GE) the balance of NBC Universal that it didn't already own. Plenty of other major deals are pending, including Dell's (DELL) proposed leveraged buyout, Office Depot's (ODP) bid to acquire OfficeMax (OMX) in what's being termed a merger of equals, the merger of US Airways (LCC) and American Airlines parent AMR, and Linn Energy's (LINE) proposed buyout of Berry Petroleum (BRY).
Now, the three newly announced deals this week-- Omnicom (OMC) and Publicis Groupe coming together in a $35 billion merger-of-equals pairing, drugmaker Perrigo (PRGO) acquiring biotech firm Elan (ELN) for $8.6 billion, and Canadian retailer Hudson's Bay (HBC) buying retailer Saks (SKS) for $2.4 billion--suggest that not only is U.S. M&A activity remaining strong but that global deal activity also may be picking up. Indeed, in all three of this week's headline deals, at least one partner is a foreign company. While the biggest headwind to further deals may be rich stock market valuations at present for potential acquisition targets, strong equity markets and historically low debt costs are continuing to create very favorable conditions for more deals. Also, corporate balance sheets remain flush with cash and plenty of private equity firms are now reaching their exit points for the flurry of buyouts that occurred in the 2005-08 time frame.
One way that investors can capitalize on heated deal activity is to seek to benefit from merger-arbitrage strategies, which involve exploiting the gap between the proposed purchase price for an acquisition target and the price at which it is trading after the deal's announcement but before its closing. A growing number of exchange-traded products have come to market in recent years to offer exposure to merger-arbitrage strategies. Academic research has concluded that investors can enjoy attractive, risk-adjusted returns from merger-arbitrage strategies. What's more, M&A-oriented products can offer bondlike returns that are typically uncorrelated with equity or bond market performance. And investors can expect better performance from merger-arbitrage funds in an environment of heightened deal activity because it offers index providers and managers more deals to invest in. Without a reasonable number of deals, the products would end up holding more cash.
Given the blizzard of recent M&A activity, it's a good time to take a look at the different strategies that have been packaged in the ETP wrapper and to see how they have done.
Under the Hood
Merger-arbitrage strategies provide exposure to deal risk--the risk that an announced deal might fall through. In general, deal risk lessens in an improving macroeconomic environment--when there is less uncertainty. Although merger-arbitrage strategies have been used for many years by institutional investors, passively managed merger-arbitrage strategies have been rolled out in the ETP wrapper only in the past several years. The strategies fit into one of two buckets. Either a product will track an index that takes long positions in a takeover target and shorts the acquiring company, or it will track an index that takes long positions in deal targets and then broadly shorts the global equity markets as a partial equity market hedge.
The largest U.S. merger-arbitrage ETP is an exchange-traded note issued by Credit Suisse (CS). Credit Suisse Merger Arbitrage Index ETN (CSMA) delivers the total return of a Credit Suisse-managed index that takes long positions in targets and short positions in acquisitors. Only deals within the United States, Canada, and Western Europe are represented. CSMA launched in October 2010 and charges 1.05%--a 0.55% investor fee plus another 0.50% index calculation fee.
Another merger-arbitrage ETP is IQ Merger Arbitrage ETF (MNA), which launched in 2009 and tracks an Index IQ-managed basket of announced takeover targets and then shorts the global market. Unlike CSMA, MNA includes global deals, which is why the fund holds a company like Germany cable giant Kabel Deutschland, which U.K. telecom firm Vodafone (VOD) recently announced plans to acquire. CSMA charges 0.76%.
Still another option is the recently launched ProShares Merger Arbitrage ETF (MRGR), which tracks an S&P-managed index of deal targets and their acquisitors. MRGR's strategy is similar to that of the Credit Suisse ETN, except that MRGR takes actual long positions in acquisition targets and actual short positions in acquisitors (in stock-for-stock deals). MRGR's index is devoted to developed-markets deals and effectively equal-weights its long positions, initiating weights of target companies at 3%. The initial weight in short positions is between 0% and 3%, depending on the terms of the deal. MRGR, which rolled out in December, charges 0.75%.
Like many market-neutral strategies, a merger-arbitrage strategy should not be compared with broad market returns. Instead, a better way to think about a merger-arbitrage strategy is to compare it with the returns of cash (three-month T-bills) in the same period and to view it as a "cash-plus" strategy. Historically, as interest rates fall (rise), merger-arbitrage returns drop (increase). With interest rates near zero but expected to rise, a merger-arbitrage strategy that generates returns in excess of cash and fees could appeal to investors with heavy bond allocations.
Relative to cash, CSMA and MNA have posted decent performance thus far in their short lives, delivering mid-single-digit returns over the past year. MNA has underperformed CSMA over longer intervals. MNA has returned less than 1.5% over the past three years, while CSMA has returned about 4% since its inception date of Oct. 1, 2010.
An Actively Managed Option
One obvious alternative to the three ETPs is Merger Fund (MERFX), an actively managed, open-end mutual fund that launched 24 years ago and that was the first mutual fund to employ a merger strategy. It has a Morningstar Analyst Rating of Silver. Merger Fund buys the stock of the acquisition target and then shorts the acquisitor's stock. In a cash deal, the fund's managers use options to hedge. One major difference between the $4.7 billion Merger Fund, which charges 1.27%, and the three merger-arbitrage ETPs discussed above is that Merger Fund is actively managed. As a result, while the three ETPs can be expected to hold all deals that fit their indexes' mandates--irrespective of the likelihood of them closing and the broader macroeconomic environment--the managers of Merger Fund have the freedom to pick and choose. Comanagers Roy Behren and Michael Shannon have put together an impressive track record selecting the most attractive pending deals based on expected risk-adjusted return. They are unconstrained by position or sector limits (although individual deal exposures seldom exceed 5% of net assets) and have done an outstanding job delivering solid returns with minimal volatility (for example, Merger slid only 5.0% during the financial crisis, during the same period (Oct. 9, 2007, to March 9, 2009) that the S&P 500 Index cratered 54.9%.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.