ETFs have been encroaching on the turf of active managers for some time and are now taking hedge funds head on. The promise of hedge funds at ETF costs is very appealing but raises the inevitable question: can they do it? The upcoming IQ Arb Merger Arbitrage ETF (MNA) is an example of one that is likely to fail.
The first thought is, of course, you get what you pay for. If this line of thinking has some validity, then alpha-generating talent is well worth paying 2/20 for. The counterargument of the indexers is, of course, that what looked like alpha in the boom turned out to be in many instances either an illiquidity premium or simply leverage. Who wants to pay a performance fee on leverage?
On second thought, we looked a little more closely at the upcoming IQ Arb Merger Arbitrage ETF. We were not impressed by what we saw.
The ETF is based on the IQ Merger Arbitrage Index, a monthly rebalanced index that is long the target companies and short – no, not short the acquirer like every merger arbitrageur in the world. They are short index ETFs (or long inverse and ultra inverse index ETFs). So the “arbitrage” and “ARB” in the fund name are really quite misleading and we are surprised that they got through the SEC. Then again, the SEC is busy looking for the next Madoff so they probably didn’t notice this naming inconsistency.
We see a number of issues with the MNA ETF:
- Monthly rebalancing: The index and ETF are rebalanced monthly. In the fast-moving world of merger arbitrage, a month is an eternity. The average merger of U.S. targets closes in 145 days (for details and industry breakdowns see Chapter 3 of our book about Merger Arbitrage), so that monthly rebalancing is sub-optimal.
- Cash holdings: 22.93% of the fund was held in cash. We don’t think that cash holdings are a problem in actively managed funds, but if you acquire a passive fund you want it to be fully invested. Then again, merger arb is a strategy that tends to have higher cash balances than other strategies due to the involuntary nature of the closing of the mergers in which the fund is invested. Nevertheless, 22.93% strikes us as a high number for any passive strategy.
- No arbitrage: The MNA ETF does not short the acquirer. It takes long only positions in companies that get acquired. To the extent that they invest in cash deals (Sun Microsystem (JAVA) is a top holding with 7.55% of the fund), there clearly are no acquirers to short. We wouldn’t mind a cash deal-only merger arb fund. But if you do stock deals you really should short the acquirer if you want to call yourself an “arbitrage” fund and give your investors that risk profile.
- Index shorting: Rather than going short the acquirer in stock-for-stock deals, the ETF and its index short index ETFs. Other than shorting, they can also buy inverse and leveraged inverse ETFs. It appears that these positions are also rebalanced monthly. At least there is nothing contrary in the prospectus or publicly available index documentation. If holdings of leveraged ETFs are rebalanced only once per month, they can lead to significant underperformance because the leveraged ETFs themselves are rebalanced daily. Much has been written about the problem with leveraged ETFs elsewhere and we refer readers to those sources.
- Risk profile: Despite its misleading name, this ETF is not an arbitrage ETF and does not have an arbitrage risk profile. It is a fund that invests in stocks that go through mergers and also shorts indices. Again, this is not an event-driven risk profile. It is more similar to a run-of-the-mill equity long/short fund. The risk profile is different from a fund that actually shorts the acquirer and therefore has deal risk as its major uncorrelated risk driver. The MNA ETF has general market risk through the long positions in the target companies with an overlay of deal risk, and hopes that statistically some of the market risk is hedged. We are not sure what sort of risk profile that is, but we would expect it to be much more correlated than a fund that provides investors with real deal risk by shorting the acquirer.
- Speculative deals: There is nothing wrong with investing in slightly speculative mergers. If done carefully it can provide significant upside. However, the key word here is “carefully”. There is no way that a passive rules-based index can invest in speculative mergers and do well. It requires good judgment, not mechanical rules. Consider, for example, the index holding of Cadbury plc (CBY). Until Monday there wasn’t even a deal, yet the index has 6.26% in Cadbury, its 4th largest holding excluding cash. The Cadbury/Kraft (KFT) deal announced on Monday is a hostile takeover at a slight discount to Cadbury’s market price. Clearly, it is not a deal without risks, and many arbitrageurs do not even touch speculative or hostile deals. In our opinion a deal with this risk profile deserves an allocation much lower than 6.26%. Again, these deals introduce more market risk into the fund than you would expect from a genuine arbitrage fund.
We are not quite sure what the implication is of replacing the short of the acquirer with a generic index short position. The implicit assumption is that the acquiring companies outperform the index while the merger is pending. We do not believe that is true but do not have data in our hands to back this up. The other question is what it does for volatility, and here the answer is more obvious: an index has a lower volatility than individual stocks, so if you replace a relatively small number of acquirers by a broad index you will have higher volatility than if you short the acquirers. In addition, the acquirer correlates very closely with the target while the merger is pending, so that an index hedge is not only second but third or fourth choice.
Overall, we do not think that this ETF has much value to investors. There are no doubt some index fanatics who will buy anything that comes in an ETF format, but serious investors who look for low correlation should stay away from this ETF. And with the absence of real arbitrage we think this ETF should not be allowed to include “merger arbitrage” in its name.
Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of Sun Microsystems as part of its merger arbitrage strategy.