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Arbitrage-free merger arbitrage

When Mebane Faber of World Beta blog fame says something we take note.  On the imminent launch of the IQ ARB Merger Arbitrage ETF (MNA) he writes:

I think most of the IndexIQ ETFs are silly, but they nailed this one.  Merger Arb ETF to hit the market, Convertible arb next?

Simply put merger arbitrage involves purchasing the shares in companies for whom there is an announced takeover transaction.  Depending upon the form of the deal the arbitrageur may take a short position in the acquiring company to eliminate the risk of the acquiring company’s stock falling in the meantime.  The risk in this strategy arises from failed deals.  Deals can fail for many reasons including a failure to acquire approval from shareholders or regulatory authorities.

There is a fair amount of academic literature on the returns to following a merger arbitrage strategy.  In a recent paper, “Merger Arbitrage and Idiosyncratic Risk”, Shane D. Shepherd reviews the literature on the topic.  He confirms the traditional finding that a merger arbitrage strategy has a non-linear beta with the market.  However after adding another factor that relationship disappears and is subsumed by this merger arb factor.  From the conclusion to the paper:

The existence of a merger arbitrage risk factor means that arbitrageurs are adequately compensated for bearing risk that is less than perfectly correlated with market risk. Merger arbitrage has often been cited as an excellent diversification tool, and this analysis supports that sentiment.

Given this finding it should not come as a surprise that merger arbitrage is a long-standing strategy employed primarily at hedge funds.  However there are a number of open-end mutual funds* and a closed-end fund* that also specialize in the strategy.  It should not be surprising that merger arbitrage was targeted by the ETF industry.

However is the new merger arbitrage ETF a good representation of the strategy?

Thomas Kirchner, the author of a book on merger arbitrage, a blogger at The Deal Sleuth and the manager of a mutual fund Pennsylvania Avenue Event-Driven Fund (PAEDX) takes issue with the new merger arbitrage ETF.  (Conflict-of-interest noted.)  While Kirchner has a number of questions about the fund’s strategy he makes an obvious point.  There is no arbitrage in the IQ ARB Merger Arbitrage ETF.  He writes:

No arbitrage: The MNA ETF does not short the acquirer. It takes long only positions in companies that get acquired. To the extent that they invest in cash deals (Sun Microsystem [JAVA] is a top holding with 7.55% of the fund) there clearly are no acquirers to short. We wouldn’t mind a cash deal-only merger arb fund. But if you do stock deals you really should short the acquirer if you want to call yourself an “arbitrage” fund and give your investors that risk profile.

The fund shorts equity indices to hedge out some of the market risk from stock deals, but it is a stretch to call this arbitrage.  That would be like calling a long-only portfolio with a long-standing equity index hedge an equity long-short fund.

Once the ETF industry moved beyond plain vanilla indices it was forced to make compromises to fit certain strategies into the ETF format.  There have been issues noted with a number of ETFs including those focused on high yield bond and commodities.  Obviously shorting the acquiror stock is no simple matter.  It requires borrowing shares and in some cases paying dearly for the privilege.  It therefore may be impossible to conduct true merger arbitrage in an ETF format.

Investors should therefore closely read the prospectus and information available from the fund to make sure that the strategy as outlined matches with their expectations.  The actively managed open-end mutual funds do, by and large, conduct traditional merger arbitrage and have multi-year live track records.  But you do pay for the privilege.  The IQ ETF has a proposed 0.75% annual fee and the mutual funds have expense ratios well in excess of 1%.

It is not clear that any investor needs a merger arbitrage fund.  That being said the existing open-end merger arb funds have garnered a critical mass of assets under management.  Nor is it clear that IndexIQ “nailed it” in constructing the fund’s (misnamed) strategy.  As is always the case with new and untested ETF strategies, caveat emptor.  Which around here means know what you are getting in an ETF, before you buy it.

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*You can find more information on the IQ ARB Merger Arbitrage ETF at the IndexIQ website.

*Shepherd, Shane D., “Merger Arbitrage and Idiosyncratic Risk” (October 13, 2009). Review of Business Research, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1488415

*The two biggest open-end merger arbitrage funds:  Merger Fund (MERFX), Arbitrage Fund (ARBFX), .  The closed-end fund is the Gabelli Deal Fund (GDL).

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