What Lies Ahead For M&A ETF?

by: Zacks Funds

Merger and acquisition (M&A) activities across a number of sectors were on a tear last year, with a record level of such activities. But the momentum for M&A - one of the major drivers of the stock market ascent in recent times - seems to be fading this year. At least, the numbers are giving such cues. The volume of global deals is $US822.2 billion ($1.1 trillion) so far this year, which represents a decline of 17% year over year.

In addition to this data, there has been a surge of failed M&A deals lately. As per data provided by Dealogic, "US targeted withdrawn M&A volume is up 64% on full-year 2015 ($231.1bn) to $378.2bn in 2016 YTD (as of May 4, 2016)." This is because several mega deals have been called off lately which took the size of U.S. oriented withdrawn M&A to a record level.

Drugmaker Pfizer's (NYSE:PFE) decision to abandon its $160 billion deal to unite with Botox maker Allergan plc (NYSE:AGN) due to the new Treasury guidance related to tax inversion is the largest called-off deal on record.

The $103 billion deal between Honeywell International (NYSE:HON) and United Technologies (NYSE:UTX) is also out of action. There was also a proposed $38.7 billion merger deal between Halliburton (NYSE:HAL) and Baker Hughes (BHI), which finally fell apart in April.

As per Dealogic, with the termination of these likely deals, investment bankers were hard hit as they lost about $1.2 billion in possible investment fees.

What's Next?

It looks like that the removal of mammoth deals in the U.S. actually inflated the size of withdrawn M&A data ($357.8 billion); the data speaks less about the diminishing number of activities. As per financial review, though there was a plunge in global M&A deal size, the number of announced transactions is 8,025 so far in 2016 versus 8,085 last year, indicating that the number has just moderated, and is far from completely losing momentum.

The stringency in the U.S. tax inversion rule is less likely to put an end to cross-border deals. Yes, it could slow the momentum, but cannot stop them altogether.

Another reason for the M&A slowdown is the underperformance of hedge funds in recent times. Notably, activists' hedge funds play a huge role in companies' merger and acquisition decisions. If the climate improves in this area, maybe M&A sector will receive a fresh lease of life. Also, being an election year, activities may remain slightly subdued in the U.S.

Plus, the banking sector is facing stringent regulation and is also caught in a trap following energy sector issues. This is because banks have considerable exposure to the energy sector, which may default on persistent low oil prices.

This scenario made the banks unsure of "how much leverage they should supply to private equity transactions, which has caused them to shy away from lending to PE-backed deals."

If the banking sector recovers in the near term, mergers and acquisitions may also perk up and investors could easily take advantage of the merger arbitrage strategy.

This strategy looks to tap the price differential (or spread) between the stock price of the target company after the public announcement of its proposed acquisition and the price offered by the acquirer to pay for the stock of the target company.

This is especially true given that investors should go long on the target or the acquired company and short on the acquiring company. When the deal is completed, shares of the target company will increase to the full deal price (in some cases slightly below the deal price), giving investors a nice profit.

How to Play?

Here are three merger arbitrage ETFs, any of which could make compelling options for investors seeking to play this area. These are the IQ Merger Arbitrage ETF (NYSEARCA:MNA), the ProShares Merger ETF (BATS:MRGR) and the Credit Suisse Merger Arbitrage Index ETN (NYSEARCA:CSMA).

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