IndexIQ, a pioneer in the area of hedge fund and inflation hedge ETFs, is preparing to launch another fund, the IQ ARB Merger Arbitrage ETF. The fund is scheduled to begin trading later this month under the clever ticker MNA. The proposed ETF will track the IQ ARB Merger Arbitrage Index, a strategy that involves investing in global companies for which there has been a public announcement of a takeover. The index also includes short exposure to global equities as a partial equity market hedge.
Merger arbitrage strategies are nothing new, but MNA represents the first time such tactics are being made widely available through the ETF structure. Merger arbitrage seeks to generate gains by purchasing stocks of takeover targets for less than the announced transaction price. By holding these investments until the transaction closes, investors can pocket the difference (see a good list of current merger arbitrage opportunities here). It sounds like a sound investment play and has the potential to deliver solid returns. But the merger arbitrage strategy comes with commensurate risk. If the deal closes, a profit can be made. But if the deal falls through, investors can be left holding the bag.
Earlier this week, Warren Buffett’s Berkshire Hathaway (BRK.A) announced the acquisition of railroad operator Burlington Northern (BNI) for $100 per share. But BNI stock is currently trading around $97 per share, with the discount to the agreed upon value attributable primarily to two factors. First, the deal won’t be completed immediately, so the $3 discount reflects in part the time value of money (essentially paying $97 today for $100 at some point in the future). But there are also risks involved in any deal, including regulatory hurdles that must be cleared before any cash changes hands. In fact, Berkshire and Burlington Northern are currently being sued by shareholders who claim the acquisition won’t maximize shareholder value.
While the likelihood of the deal falling apart is minimal, the consequences to investors if it does can be material. Prior to the announcement, BNI was trading around $76 per share, and it would presumably return to near that level if the acquisition was suddenly off the table. Because the outcome is binary – either a deal is done or it isn’t – the standard deviation of the expected return to investors is significant (meaning higher risk).
MNA probably won’t be a core portfolio holding for most investors, but it has the potential to be a very powerful tool for those looking to round out their holdings with a fund that has the potential to enhance overall returns. The ETF will charge an expense ratio of 0.75%.
Disclosure: No positions at time of writing.