Credit Suisse announced the launch of its fourth ETN today, rolling out a product offering leveraged exposure to a merger arbitrage strategy. The 2x Monthly Leveraged Credit Suisse Merger Arbitrage Liquid Index ETN (CSMB) will be linked to an index consisting of stocks that are proposed takeover targets, delivering 2x leveraged exposure on a monthly basis. Credit Suisse debuted a merger arbitrage ETN in October 2010, and CSMA has seen assets grow to about $55 million since then. CSMB will be linked to the same index underlying CSMA, but will deliver monthly returns equal to 200% of the change in the underlying index over that month.
A merger arbitrage strategy involves purchasing stocks of companies after a proposed acquisition is announced. Once a transaction is announced, there are still certain obstacles to completing a deal; there may be regulatory hurdles to be cleared or shareholder objections to a proposed deal (for example, a clinical data shareholder recently filed a lawsuit claiming the proposed acquisition by Forest Laboratories “is inadequate and significantly undervalues the company”). In addition, it can take several months for firms to complete a proposed acquisition, meaning that a discount to reflect the time value of the month is often applicable to takeover targets. So while the share prices of target companies often jump after a deal is announced, they tend to trade below the proposed purchase price as a reflection of the risk that the acquisition will ultimately fall through. Components of the index underlying CSMB include:
- Qwest Communications (Q): In April 2010 Qwest announced that it had agreed to be acquired in a transaction that would give shareholders 0.1664 shares of CenturyLink (CTL) for each Q share. CTL closed at $40.81 on March 3; Q stock finished that session at $6.75, a slight discount to the value of the shares that would be received in the transaction.
- Progress Energy (PGN): In January Duke (DUK) agreed to buy Progress for $47.48 per share, a premium of about 6% over the average closing price in the previous 20 sessions. PGN finished trading last week at $45.70, a discount of nearly 4% to the proposed purchase price.
The merger arbitrage strategy is designed to capture the spread between the price at which the stock of a target company trades after the acquisition is announced and the price the acquiring company has proposed to pay. If all goes smoothly and the deal is completed, the strategy can deliver positive returns with low volatility. There is a risk, however, that an announced transaction will fall through. In that case, any gains that the target company posted immediately after the transaction was announced often disappear.
Because the outcome is often binary - a transaction is either completed or it falls through - investing in takeover targets can be a risky proposition. As such, this strategy lends itself quite nicely to the ETF structure, since accessing a basket of target company stocks can diversify the risk of any one deal falling through. The merger arbitrage strategy has been a favorite tactic of hedge funds for decades, but its introduction in the ETP wrapper is a relatively new innovation. In addition to CSMA, IndexIQ offers the IQ Merger Arbitrage ETF (MNA).
Like CSMA, CSMB is structured as an exchange-traded note. That means the security is a debt instrument issued by Credit Suisse whose return is linked to the performance of a specified index. Most investors are aware of some of the potential advantages and drawbacks of the ETN structure: Investors are exposed to the credit risk of the issuing institution, but are able to avoid tracking error that often exists in ETFs.
In the case of the merger arbitrage strategy, there are some additional potential advantages to utilizing an ETN. This structure may be more efficient than traditional mutual fund or ETF wrappers because investors in an ETN are likely to be taxed only upon the sale of the note. Because a merger arbitrage opportunity often involves holding securities for less than a year (assuming that the period between the announcement and consummation of a deal is less than 12 months), there is the potential to incur short-term capital gains. At the end of 2010, MNA made a short-term gain distribution of about $0.32 per share, which represented about 1.3% of the fund’s NAV at the time.
CSMB joins a number of new ETNs that may address the potential tax inefficiencies of investment strategies. RBS has launched a suite of “Trendpilot” ETNs that are linked to indexes designed to replicate a trend-following strategy. Such a technique often involves buying and selling securities based on momentum factors, which can result in material transaction costs and tax burdens.
Credit Suisse Lineup
CSMB is the fourth ETN in the Credit Suisse family; in addition to CSMA, the company also offers a long/short product (CSLS) and the Cushing 30 MLP ETN (MLPN). At the end of February aggregate assets totaled more than $200 million. Credit Suisse is also behind the recently launched VelocityShares ETNs that offer exposure to futures-based volatility indexes.
Disclosure: No positions at time of writing.
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