Seeking Alpha
What is your profession? ×
Profile| Send Message|
( followers)

By Dave Nadig

IndexIQ’s new IQ Arb Merger Arbitrage ETF just started trading, but I’m not sure I buy it.

The new ETF (NYSEARCA:MNA) launched Tuesday, as Cinthia Murphy covered in the news. She does a good job laying out the core objective: Buy the stocks of companies that will be gobbled up, and short out a bit of broad market exposure, thus capturing only a theoretical premium of the merger companies.

There’s nothing inherently flawed in the idea here, and I have no doubt that the IndexIQ guys will deliver on the letter of the prospectus. I’m just unconvinced this is a strategy that needs an ETF.

Like most niche ETFs, MNA tracks an essentially self-referential index: the IQ Arb Merger Arbitrage Index. This index is a quantitatively based stock-picking index, which selects stocks based on a public methodology available here.

The idea behind the methodology is to perform the function of a hedge fund manager mechanically. Here’s how the methodology works.

  1. Look at every company on dozens of international markets, and make a big list of those that are the subject of an announced merger, acquisition, LBO or private equity investment where more than 50 percent of the company is on the block.
  2. At the beginning of every month, when the index is rebalanced, look at the price of the offer in the market, the actual price of the stock, and the price of the stock way back before the deal was announced. Based on those factors, include or exclude each company from the index. The logic is fairly straightforward—companies with offers outstanding over the current price have a higher probability of completing a merge to the upside; companies in the opposite position are stinkers. There’s some nuance, but ultimately, it’s cocktail-napkin logic.
  3. These stocks are then weighted based on average trading volume. Companies that are hotly traded get a big slice of the pie. Companies (even big companies, theoretically) that have low liquidity get small weights.
  4. Cap every stock at 15 percent, then scale the whole portfolio down to make room for a 10 percent short position using inverse and leverage-inverse ETFs.
  5. Any money left over goes in short-term bond ETFs.

Let’s look at the portfolio this mechanical process currently generates, as of 11/16/2009:

Component

Weight %

ISHARES BARCLAYS SHORT TREASURY BOND FUND

29.11

STARENT NETWORKS CORP

8.73

BJ SERVICES CO

8.3

SUN MICROSYSTEMS INC

7.87

CADBURY PLC

6.39

AFFILIATED COMPUTER SERVICES

6.02

MARVEL ENTERTAINMENT INC

5.68

VARIAN INC

4.28

PROSHARES ULTRASHORT S&P500

4.26

ULTRASHORT MSCI EAFE PROSHARES

4.25

MPS GROUP INC

4.19

There are obviously a handful of other holdings as well, but the weights drop precariously from here.

The problem I have with this portfolio isn’t that it’s somehow “bad”—I’m not an M&A specialist. Maybe Starent (STAR-OLD) and BJ Services (BJS) are screaming buys. The problem I have is that by definition, the kind of arbitrage that an active hedge fund manager seeks to exploit is based on asymmetrical information. Many, many smart investors have already weighed the probabilities of, for example, Oracle’s (NYSE:ORCL) proposal to buy Sun Microsystems (JAVA). They’re evaluating the books, and perhaps most importantly, responding to news. In the case of nearly every M&A situation, there are blockades that arise and dissolve on a daily basis (in the case of Sun, concerns from European regulators). Those news items often ping-pong a stock’s price back and forth around a hanging offer.

Because an index by definition has to follow certain rules, its hands are tied when circumstances change.

To be sure, there are plenty of loopholes in the methodology to allow IndexIQ to avoid being in stocks that are no longer relevant. But fundamentally, this kind of arbitrage is the most active of active management. It’s about constantly assessing probabilities based on public news flow and private conversations. I remain unconvinced an algorithm, especially a relatively simple one, can capture that.

The second issue I have is this: I’m not keen on the layering of ETFs. Nearly 40 percent of the portfolio is in ETFs, which themselves carry an expense ratio (over 90 basis points in the inverse ETFs). IndexIQ has stated its desire to construct the short position more efficiently, but for the moment, the actual index methodology specifically says it will base its returns on a “10% aggregate allocation (no more than 5% each) to at least 2 inverse and/or ultra inverse ETFs.”

And last, I hate paying someone to manage my cash. I understand that the ETF needs to have the flexibility to simply not be in the market when there are no opportunities, but that’s not why I’m paying a 75 basis point management fee.

Sorry guys. I understand the intent, and I’m sure the academic finance backs up the algorithm, but I’m not sure I buy it.

Original post