With corporate balance sheets flush with cash, there has been a lot of talk recently about the potential for an M&A bonanza. This, of course, would provide opportunities for merger arbitrage hedge fund managers. Whether you consider their returns to be a fair compensation for the successful completion of deals or the result of pure skill, research has shown that merger arb has produced positive returns over time.
We noted in late 2009 that merger arb has shown a particularly high correlation to the S&P 500 in recent years. And academic studies have shown that “arbitrage spreads” have been falling since 2002. Some say this is emblematic of a growing capacity constraint in the strategy. But regardless of their source or recent declines, merger arb returns have averaged around 1% per month over several decades.
Merger arb funds provide “insurance” against deal failure by going long the target and short the acquirer, under the assumption that prices tend to converge before they merge. But you can also set up merger arb trade by using options. In fact, previous research cited in a new academic paper found that according to one survey, 20 of 21 arb managers actually did that. Yet most academic studies are based on a “classic” merger arb style that uses equity positions only. The new academic study (“Profitability of option based merger arbitrage” by Haitao Li of the University of Michigan and Xuewu Wang of the University of Scranton) actually concludes that a passive options-based arbitrage strategy is “a lot more profitable” than a stock-based one.”
Li and Wang set up two passive strategies – one using stocks and one using options – and pit them head to head in a horse race beginning in 1996 and ending in 2008. To ensure an apples-to-apples comparison, the strategies only trade deals where there are options available on both the target and on the acquirer. Further, they only look at cash offers (not complex offers that include warrants or collars).
The stock-based strategy does remarkably well, producing a return of 130 basis points a month.
The options-based strategy simultaneously goes long call options on the target’s stock and long put options on the acquirer’s stock. If the deal succeeds, the target’s stock will increase, making its call options more valuable and the acquirer’s stock will fall, making its put options more valuable. If the deal fails, the opposite will happen and the options may expire worthless.
But wait, you say, what about the other factors that determine the value of an option? Volatility, for example. As Li and Wang point out, an options-based merger arb strategy bets not just on equity price movements, but on options price movements, a “vastly different” thing. Options buyers, for example, can also choose between options with different liquidity and leverage, allowing them to amplify returns (and volatility). In fact, the passive options trading methodology used by Li and Wang seeks out “options with the greatest price change for a given change in underlying stock prices.”
The other wild card when using options for merger arb trades is that you don't know when the deal might close. The liquidity/leverage-driven algorithm used by Li and Wang placed trades in options with an average maturity of 113 days for calls and 53 days for puts. But the average time to close each deal was 125 days.
Here’s how the horse race went between stock-based and options-based merger arb algorithms…
The stock-based approach did okay, with a monthly return of 0.84% with a daily standard deviation of 1.17%…
But the options-based approach posted an average monthly return of 1.32% with rather eye-popping daily standard deviation of 2.25%…
That return is after a death-defying fall from being 4500% up to being only around 1700% up. Unfortunately, Li and Wang give this roller-coaster only a passing reference:
While we don’t analyze the cause of this decline further, we notice this time period coincides with the market downturn caused by the subprime crisis.
This begs the question of whether the higher return is simply fair compensation for higher (and highly intermittent) volatility. The duo adjusts these raw returns for Fama French factors and concludes that:
…while both strategies generate significant abnormal returns that are robust to asset pricing factors, option-based merger arbitrage is more profitable than stock-based merger arbitrage.
…As long as you don’t wear a pacemaker or have some kind of panic disorder.