Note: Matt Staub, an economics graduate student at Temple University co-authored the following post.
Like many investors who pay attention to valuations, we are concerned about the relatively low returns we expect from both stocks and bonds over the next few years. Coupled with concerns about the condition of the global economy and its myriad problems, these expectations have led us to start searching for alternatives to traditional stocks and bonds and their mutual fund equivalents.
One such alternative is mutual funds whose mangers practice merger arbitrage strategies. Arbitrage is defined as the simultaneous purchase and sale of an asset in order to profit from a difference in price. It is a trade that creates a profit by exploiting short-term price differences of identical or similar financial instruments. Simply stated, arbitrage opportunities exist as a result of market inefficiencies, and arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. Such strategies have long been the bread and butter of hedge fund managers.
Merger arbitrage is one specific type of arbitrage. It is important to distinguish merger arbitrage from typical long/short strategies based on market timing. Merger arbitrage is an event-driven strategy. When a merger is announced, the stock price of the target company generally trades at a discount to that offered by the acquirer until the deal closes. This discount reflects the tension between the likelihood that the deal will close at the stated terms and the willingness of holders of the target company’s stock to sell at a discount to lock in gains and avoid the risks if the deal fails. Merger arbitrageurs provide liquidity to holders of target stocks who often sell after a merger or other corporate event is announced. Basic implementation of merger arbitrage involves taking a long position in the target company and a short position in the acquirer (in a stock only deal). The art of this trade is to structure the positions such that when the merger closes a return is produced that exceeds a preset hurdle rate. The hurdle rate is usually based on a risk free rate like the prevailing 30 day T-Bill rate or LIBOR. Typical of this strategy is The Arbitrage Fund ( ARBFX) which has a target return of the T-Bill plus 400 basis points.
Most mainstream forecasters are indicating that returns for stocks and bonds will be mediocre in the near future. The economic outlook is uncertain and could get considerably worse. However, many corporations are currently flush with cash reserves from their efforts to prepare for financial Armageddon sixteen months ago. With excess cash reserves and the expectation that interest rates will remain low, at least in the near term, corporations are in a position to finance economically justified mergers and acquisitions. This should provide merger arbitrageurs with plenty of trade fodder.
As with any investment opportunity, it is important to consider the positive and negative aspects of merger arbitrage. As a result of hedging with short positions, merger arbitrage funds hold up well in bear markets because the short positions do well in a falling market. In bull markets, however, merger arbitrage can severely under-perform, again due to the short positions. Therefore this strategy is not for aggressive investors that are sensitive to equity under-performance. Additionally, funds concentrating on merger arbitrage are not cheap to own. This investment strategy is highly specialized work done by mathematically gifted traders, and there is a great deal of discipline and expertise required. Management fees typically run one half to three quarters of a percent higher than equity mutual funds. However if you are a moderate risk investor who is not concerned about missing a major upward market move, merger arbitrage funds can provide some return in a moribund market. There are a number of funds available whose managers are excellent practitioners of the arbitrageur’s art. Consult your independent, fee-only investment advisor for more information and guidance.