Nickel-and-Dime Your Way Through M&A With This ETF (MNA)

From Grant Wasylik: Have you ever profited from an investment strategy where you consistently banked easy, small returns?

Where it seemed almost too good to be true … until it wasn’t.

Eventually your strategy — and profit — got wiped out by some type of financial event.

In hindsight, you were “picking up nickels in front of a steamroller.”

It’s possible. You can use an old hedge fund strategy called merger arbitrage.How would you like to pick up pennies, nickels and dimes — and lots of them — without having to worry about that steamroller?

Merger arbitrage seeks to profit from the discrepancy between the acquisition price and the price at which the company’s stock trades before the consummation of a merger.

It works like this …

Typically, when a takeover deal is announced, the stock price of the acquisition target spikes significantly.

However, it doesn’t jump all the way to the offer price until the transaction is complete (or just before). The reason it doesn’t is because there’s a risk that the deal could fall through.

A merger arbitrageur goes to work after an M&A deal is announced.

Here’s an example …

Back in the summer months of July and August 2010, Burger King was trading in the $17 range. On Sept. 9, 2010, 3G Capital made an offer to acquire Burger King at $24.

Burger King moved up to around $23.60 on the announcement.

If you would have purchased shares of Burger King that day at $23.60, you could have sold your shares to 3G Capital at $24 on Oct. 20, 2010 (deal completion day).

A 40-cent gain, +1.7% in this case, may not sound like much. But, it occurred in a short span of 42 days. So, it equates to annualized return of +15.8%.

If you bought Burger King shares on the deal-announcement day, you could have made a 1.7% gain in 42 days. (That’s 15.8% annualized.)

Now, not every deal is completed successfully. And not every deal achieves the same returns of the Burger King example.

But, by and large, the amount of deals, the success rate, and the average returns over a short duration of time are all appealing …

From 1997 to 2009, 8,137 global deals were completed or canceled. 83% of those deals, or 6,789, were successfully concluded.

The average return from the day after the announcement until completion (114-day average) was +8.03%.

The deals that were ultimately canceled had an average return of -3.95% over an average of 117 days.

That’s the goal of merger arbitrage. Book a bunch of small gains with a high probability of success … and let the numbers multiply over time.

I know financial advisers who use it as an equity allocation … some put it in their fixed-income bucket … or others shift it into an alternative sleeve.This hybrid approach doesn’t fit into an easy box …

As an equity allocation, merger arbitrage makes for a nice hedge in a bear market.

Treated as a fixed-income substitute or supplement, it has a good shot of outperforming traditional fixed-income securities in a low-rate world.

And utilized as an alternative, it can generate consistent returns that should fall somewhere between the returns of stocks and bonds in the long run.

It’s pretty much lived up to those expectations …

In 2008, for example, the three longest-standing mutual funds in the merger-arbitrage space — The Merger Fund (MERFX), Arbitrage Fund (ARBFX) and Gabelli ABC Fund (GABCX) — were down -2.3%, -0.6% and -2.6%, respectively. The S&P 500 lost -37% that year.

Annualized returns from for the last eight years (2009-’16):

• IQ Merger Arbitrage Index … +6.0%

• BofA ML U.S. 3-Month U.S. Treasury Bill Index … +0.1%

• Barclays U.S. Aggregate Bond Index … +3.9%

With the S&P 500 Index’s annualized return of +14.8% from 2009 to 2016, merger arbitrage returns fell in the middle of bonds and stocks. The IQ Merger Arbitrage Index also cranked out steady returns each year: +5.6% (2016), +2.3% (2015), +6.2% (2014), +8.7% (2013) and +2.5% (2012), -0.2% (2011), +1.0% (2010) and +22.2% (2009). 2009 was a big bounce-back year after the index fell -18.3% in 2008.

Granted, all that performance is in the past …

So, why does merger arbitrage represent a good investment opportunity for the future?

Five main reasons, in my estimation:

1. Deal activity. According to IndexIQ research, deal volume for the first three months of 2017, relative to Q1 in prior years, indicates deal activity remains robust. Since 2005, Q1 2017 has the fourth-highest overall deal volume … and the third-highest average deal size … of all other Q1 periods.

2. Lots of cash on corporate balance sheets. FactSet reports S&P 500 companies (ex-financials) had $1.54 trillion of cash and short-term investments on their balance sheets at the end of October 2016. That balance is the largest cash total in the last 10 years. Meaning, many companies are armed with a large stockpile of buying power.

3. Interest rates are low. If you are one of those companies who isn’t flush with cash — or management has its cash hoard earmarked for other endeavors — rates are enticingly low. Meaning, companies can borrow cheaply to finance deals. And cost of capital is low … so there’s a low barrier to make a deal attractive.

4. Low-growth environment. Companies aren’t growing organically. Therefore, they’re relying on strategic M&A to spur growth.

5. Extended bull market. We’re in the second-longest bull market for the S&P 500 in history. (And the longest for the Dow Jones Industrial Average.) If you have overindulged in stocks, then slicing off a piece of your equity pie for merger arbitrage could serve as a nice hedge — and diversifier — for your portfolio.

So, what’s the best way to play this space?

Honestly, it’s too difficult for most individual investors to engage in every deal themselves. Deal activity adds up to trillions of dollars — and thousands of deals — each year …

Source: Thomson Reuters/Gabelli Research

So, an investor could consider an actively-managed mutual fund. For instance, any of the three actively managed funds mentioned earlier: The Merger Fund (MERFX), Arbitrage Fund (ARBFX) or Gabelli ABC Fund (GABCX).

I’ve met the lead portfolio managers (Roy Behren and Michael Shannon — The Merger Fund … John Orrico — Arbitrage Fund … and Mario Gabelli — Gabelli ABC Fund) of all three funds. They’re all incredibly smart individuals.

If M&A activity dries up or lots of deals go bust, these funds could do well — guided by their seasoned managers.

But in the recent past, there’s been a better choice …

The IQ Merger Arbitrage ETF (MNA).

Over the last five years, this ETF has outperformed all three of these age-old, veteran-run merger arbitrage funds …

MNA is up 20% over the past five years. Gabelli’s ABC Fund is the next-best performer, up 15% in that time frame.

The cumulative returns in the chart above convert to these five-year annualized returns: MNA (+3.7%), GABCX (+2.9%), MERFX (+2.1%) and ARBFX (+1.6%).

While MNA hasn’t been around as long as its actively managed competitors, it did launch on Nov. 17, 2009.

Per the prospectus, its investment strategy uses a mechanical approach to invest in merger arbitrage:

The Underlying Index seeks to employ a systematic investment process designed to identify opportunities in companies whose equity securities trade in developed markets, including the U.S., and which are involved in announced mergers, acquisitions and other buyout-related transactions.

The Underlying Index seeks to capitalize on the spread between the current market price of the target company’s stock and the price received by the holder of that stock upon consummation of the buyout-related transaction. In addition, the Underlying Index includes short exposure to the U.S. and non-U.S. equity markets.

I talked to Salvatore Bruno, CIO at IndexIQ Advisors, who told me:

While not a new strategy, offering merger arbitrage in an ETF affords investors easy access to this potent portfolio tool in a cost-effective, transparent and tax-efficient vehicle.

We have seen a big uptick in fund inflows as advisers are taking advantage of the fund’s consistently positive returns, coupled with its low volatility and low correlation to broad equities and bonds, to improve the efficiency of their clients’ portfolios.

With merger activity continuing to remain robust, the positive environment for a merger strategy should continue.

Here are the top 10 holdings as of March 31, and some M&A details on each:

Source: New York Life Investment Management

MNA is also cheaper than the trio of actively managed funds. It charges 0.77% in expenses.

In contrast, the average expense ratio of the three mutual funds is 1.20%. The Gabelli fund has a low expense ratio of 0.60%, but it also carries a minimum investment of $10,000.

If you’re interested in generating attractive risk-adjusted returns outside of stocks and bonds (i.e., scooping up steamroller-free nickels and dimes), merger arbitrage is a good place to start your search.

Judging by the $6.3 billion in combined assets of four of the top merger arbitrage funds, it’s clear that most everyday investors aren’t informed of this strategy’s merits.

To learn more about the IQ Merger Arbitrage ETF (MNA), click here.

The IndexIQ IQ ARB Merger Arbitrage ETF (NYSE:MNA) was unchanged in premarket trading Thursday. Year-to-date, MNA has gained 3.52%, versus a 8.20% rise in the benchmark S&P 500 index during the same period.

MNA currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 20 ETFs in the Alternative ETFs category.

This article is brought to you courtesy of Uncommon Wisdom Daily.

About the Author: Grant Wasylik

grant-wasylikGrant Wasylik is an analyst and editor for Uncommon Wisdom Daily — a division of Weiss Research.

Before joining the investment newsletter business, Grant worked as a portfolio manager, lead research analyst and head trader for a billion-dollar wealth management firm for 10 years. He also spent a few years working in a specialized risk-trading department at Charles Schwab — where he was the first-ever, external hire into this elite department. In his first stint in the securities business (after passing Series 7, 64 and 24 exams), Grant ran a margin department and supervised a trade desk for a discount brokerage firm.

Prior to coming to Uncommon Wisdom Daily, Grant was co-editor and chief analyst of The Palm Beach Letter for two years. This monthly publication — with over 70,000 subscribers — focused on safe, income-oriented investments.

Due to his vast investment experience, Grant has a deep contact list comprised of 400-plus mutual fund, ETF, index, hedge fund and other top-notch financial professionals. In addition, he receives special invitations to — and attends — several of the world’s top investment conferences each year.