Wednesday, April 11, 2012

Picking Up Nickels In Front Of A Steamroller

How Merger Arbitrage Funds Work

For many investors, finding new ways to diversify their portfolio and reduce risk while still making an adequate return is a constant struggle.  As trading costs and barriers to capital flows have come down, markets have become more integrated over time reducing the benefits of diversification.  Worse, in times of market stress in the past several years correlations between different types of assets have approached totality (with the exception of now very low return treasury bonds).  So the hunt is always on for assets with low correlation and positive return.  One of the options available to retail investors are merger arbitrage funds, such as the Merger Fund (MERFX) and the Arbitrage Fund (ARBFX).  These specialized funds offer positive (if modest) returns, very low correlations to most other asset classes, and very low volatility (its like watching paint dry).  But before running out and clicking "buy" investors should understand how these funds work and what the risks are.

The basic concept of what merger arb funds do is pretty simple.  Suppose company A announces that it has struck a deal to buy company B for $50 a share.  Company B's stock jumps from wherever it was to something short of $50, say $47.  Why doesn't company B's stock trade immediately at $50?  There are several reasons, but the most important are time and deal risk.  First, there is some risk that the deal will not go through as planned.  It does not happen often, but there are a number of reasons why a deal might suddenly be off.  The target could suddenly deteriorate, the buyer might not be able to raise the funds required for the purchase, the anti-trust authorities could block the deal, etc.  So the market prices in the risk of the deal not happening in the form of a discount to the sale price and many investors who own the target are happy to sell at a bit less than the deal price and not take the risk (if you bought shares of company B 3 years ago at $15 you would probably be very happy to sell at $47).  The second reason company B's shares trade at a discount is simply time value of money.  Even if there were zero deal risk, there would be some discount because it takes time (generally months) for the deal to close.

Anyway, with company B's stock trading at $47 and the deal expected to close in 4 months, lots of long term holders of company B's stock wish to sell and walk away with their winnings.  Who are they selling to?  Enter the merger arbitrageurs, including MERFX and ARBFX.  The proposition to these investors is that they can buy at $47, wait 4 months, and collect $50.  The return is 3/47 = 6.4%.  Since this only takes a third of the year, annualized returns are in the double digits.  Of course there is significant deal risk, which is exactly the reason the long term holders of company B shares are selling at a discount.  Merger arbitrageurs mitigate this in a number of ways, most importantly by investing in a large number of deals so that any one deal falling apart does not make much of an impact on the portfolio as a whole.  Arbitrageurs also mitigate deal risk through very good due diligence and sometimes by options strategies (perhaps by buying put options on company B's shares in our example).

MERFX and ARBFX do exactly what is described above with the added complication that many of the deals are a bit more complex in structure than a simple all cash deal.  A very common structure is for company A to pay $50 per share of company B in the form of its stock.  In that case, the arbitrageur buys company B and shorts enough company A shares so that when the deal closes the arbitrageur will simply pocket the merger spread.  This is an important point, as well will discuss in a moment.  Both funds routinely have 50 to over 100 deals in the fund at any given time, which greatly reduces the risk of a single blown deal trashing the fund.

A key attraction of these funds is that they have very low correlation to other asset classes and very low volatility.  In the horrendously awful year of 2008, ARBFX lost less than 1% and MERFX lost just over 2%.  Since these funds do go out and buy equities, you might wonder why they did not get clobbered like every other equity fund.  The answer lies in the structure of most deals which include shares of the acquirer as (possibly partial) payment for the target.  In order to invest in such a deal, the arbitrageur buys shares of the target and shorts shares of the acquirer.  In an equity market meltdown correlations spike and everything plunges at the same time.  This proves lots of protection against poor equity markets as the fund is mostly market neutral due to the short positions in the acquirers offsetting the long positions in the targets.

Returns of these funds vary, and some years are better than others.  Over the last 10 years, MERFX gained about 3.5% annually and ARBFX gained 4.7% annually, both in the same neighborhood of the S&P500 at about 4% annually.  However, the arbitrage funds did so at vastly lower risk and with a much smoother ride.  Deal performance tends to follow the number and size of deals.  In years when there are lots of deal being done, returns tend to be better.

All of this sounds great, but there are catches as always.  First, these funds are exposed primarily to deal risk.  If lots of deals fail, these funds will get hurt.  Second, as an investor in such a fund you are dependent upon the managers of the fund doing a good job, not getting sloppy or making too many mistakes, and not allowing so much money into the fund that they end up chasing bad deals.  Third, these funds are decidedly NOT tax efficient (holding them in an IRA would largely resolve this problem).  Fourth, these funds are essentially short volatility.  When volatility increases, expect to see these funds drop temporarily.  Finally, there is some equity market exposure in these funds, so you won't entirely escape equity market risk.

One other issue worth noting is that these funds are both relatively expensive, with expense ratios north of 1% annually.  With index funds available at less than .10% annually, that is a lot of cabbage.  Given the specialty nature of these funds, the diversification they offer, and the need for talented managers at the helm, I can justify the expense to myself.  Perhaps you cannot.

As always, be careful, consult your advisor, do your due diligence, and take your own risks.  This is not intended to be investment advice.  You CAN lose money at this stuff.

Disclosure: Long ARBFX and MERFX.

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