Most investors don't meet the requirements to invest in hedge funds. And let's face it: even if they did, they probably shouldn't. According to CNBC, hedge funds beat the S&P 500 for the first time in a decade in 2018 by losing 4.07 percent instead of the 4.38 percent loss by the S&P. Even the good headlines are downright mediocre when it comes to the hedge fund industry. We can argue about the fairness of comparing hedge fund returns to the S&P 500 and about lumping macro hedge funds in with market neutral hedge funds. I am certain that there are some hedge funds that provide a useful service to large investors: in particular, market neutral funds that are uncorrelated with the market and provide steady positive returns. But the majority of hedge funds should be avoided, and it can be difficult to judge which ones are which until it's too late.
But just because hedge funds have trouble overcoming their high fees doesn't mean that they don't produce good ideas that retail investors can get in on. Three categories of event-driven ETFs have a history of outperformance and can add excess returns at a fraction of the cost.
Corporate spin-offs occur when a corporate action splits off a piece of a company as a separate standalone company. When this occurs, investors who own shares in the parent company receive shares in the new company. Spin-offs have a 50-year track record of outperforming the broader market. This effect has been studied by academics for decades, as persistent market inefficiencies serve as a counterpoint to the efficient market hypothesis.
The most famous study of corporate spin-offs is "Predictability of Long-Term SpinOff Returns" by McConnell and Ovtchinnikov, which tracks the performance of spin-offs from 1965 to 2000. They conclude that "an investor who followed the strategy of investing in every single spinoff was actually able to beat the market over most of the intervals considered."
In a follow-up study, McConnell, Sibley, and Xu examine spin-offs from 2001 to 2013. Most notably, they examine whether buying a spin-off ETF also produces excess returns. In addition to concluding that the outperformance of spin-offs continued for the 13 years after the original study, they concluded that while the spin-off ETF performed worse than the time intensive practice of investing in each spin-off individually, the ETF did indeed produce excess returns.
There are numerous theories about why this outperformance occurs, from more focused companies, to more engaged management, to the market assigning a higher multiple to specific industries over conglomerates. Most of these explanations fall flat, because the market should properly discount these effects. The most likely explanation is the investing mandates of funds and ETFs, and the behavior of retail investors. If an S&P 500 company spins off a portion of its business, every ETF and mutual fund that has a mandate to invest only in the S&P 500 is forced to sell those shares. Every fund with a large cap mandate must sell newly acquired shares of a mid-cap or small-cap company. And most retail investors when they notice an odd lot of shares in an unknown company in their account that they didn't choose to invest in will simply sell those shares. These actions by investors and fund managers cause the shares of newly spun-off companies to become artificially depressed, thus resulting in excess returns for those willing to buy those underpriced shares. This rationale explains why the effect persists despite it being well-known.
So how can we get in on it? There is a single spin-off ETF with a reasonable amount of liquidity and assets under management:
Invesco S&P Spin-Off ETF (NYSEARCA:CSD)
- Expense Ratio: 0.64%
- Market Cap: $150 million
- Average Daily Volume: 4,000 shares
Investing in this ETF requires a small leap of faith as it has underperformed the market over the past five years. We should remember though that just because a strategy is a winning one doesn't mean it will win every year. Despite its recent spate of weak performance, it has still outperformed the S&P 500 over the past 10 years (and as we know from academic research, for many years before that). With only $150 million under management, and more hedge funds closing than opening over the past several years, it seems unlikely that this strategy is saturated to the point where the edge has disappeared. More likely, a statistical outlier or two has hurt the results in the short-term, but we can expect further excess returns going forward.
Fallen Angel Bonds
Fallen angel bonds are formerly investment grade bonds that have been downgraded to junk bond status. These bonds present a very similar value proposition as corporate spin-offs. In this case, there are many funds with mandates to only own investment grade bonds. When those bonds are downgraded to junk, these funds are forced to sell regardless of price. Similarly, many retail investors regard investment grade bonds as safe investments, and junk bonds as risky. After all, it's in the names. Many investors who believed they were buying a safe asset will sell after a ratings downgrade and a sharp price decline. These two effects artificially depress prices for fallen angel bonds and produce an opportunity for investors.
While there is a lack of academic research on the subject, the largest Fallen Angel ETF has a good track record of producing positive alpha, outperforming both investment grade and junk bond funds over the past several years.
VanEck Vectors Fallen Angel High Yield Bond ETF (NYSEARCA:ANGL)
- Expense Ratio: 0.35%
- Market Cap: $925 million
- Yield: 5.5%
- Average Daily Volume: 300,000 shares
iShares Fallen Angels USD Bond ETF (NASDAQ:FALN)
- Expense Ratio: 0.25%
- Market Cap: $70 million
- Yield: 5.7%
- Average Daily Volume: 30,000 shares
With nearly $1 billion invested in this strategy through ETFs, it is natural to wonder if this strategy has run its course and whether the excess returns can continue. It is important to keep in mind that the size of the bond market is almost double the size of the equity markets, and the size of the US corporate bond market is measured in trillions.
While it is certainly possible that the excess returns of fallen angel bonds won't continue, news reports from CNBC and warnings from the BIS, the IMF, various federal banks and investment firms indicate that the bigger risk is to investment grade bond holders who may be forced to sell fallen angel bonds in the event of an economic downturn. If there is danger for investment grade bonds from these downgrades, then there is continued opportunity for Fallen Angel ETFs.
Merger arbitrage typically involves purchasing takeover targets after a deal is announced, and shorting the acquiring company. As the deal approaches and eventually concludes, the spread narrows and then disappears, producing a small absolute return with low correlation to the stock market.
While this strategy has typically been the province of hedge funds, it has also been used successfully by mutual funds for decades. The Merger Fund (MUTF:MERFX) has been operating for 30 years and has an expense ratio of 1.91%, while the Arbitrage Fund (MUTF:ARBFX) has been operating for 20 years and has an expense ratio of 1.94%. Only within the past decade has the strategy been adapted to the lower cost and tax efficient ETF world.
IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA)
- Expense Ratio: 0.78%
- Market Cap: $950 million
- Average Daily Volume: 200,000 shares
This ETF takes a slightly different tack than the traditional merger arbitrage fund. Instead of shorting the individual acquiring companies, it shorts industry ETFs to neutralize industry exposure and reduce transaction costs. Despite this different approach, the ETF has produced steady returns over its nine years of existence, averaging a 3% return per year with a low correlation to stocks and bonds, generating positive alpha.
If you are looking to outperform the market without paying high fees, these three categories of event-driven ETFs are backed by strong track records and academic research. Corporate spin-offs, fallen angel bonds, and merger arbitrage can be easily substituted for a portion of an investor's stock, bond, and cash allocations respectively, offering the potential of excess returns at a low cost. And even if you devote all of your portfolio to individual stocks and bonds, these successful strategies could help inform your next purchase.
Disclosure: I am/we are long CSD, FALN, MNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.