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With markets facing some severe weakness as of late, many investors have looked to uncorrelated plays as solid investments. Unfortunately, many of these typical investments—such as bonds, gold, and low volatility stocks, have not held up well either, and have in many cases underperformed broad markets.

This is forcing many to look at new avenues for funds that can still hold up in uncertain economic environments. One such space that you may not have considered yet but that could certainly fit the bill is the merger arbitrage space.

What is Merger Arbitrage?

This strategy looks to focus on companies that have been announced as takeover targets, as well as the companies that are doing the acquiring. Generally speaking, when such a deal is made public, the firm being acquired will see its share price rise close to—but not all the way up to—the acquisition price.

The difference between what the target company trades at and the deal price is there due to some uncertainty about the deal going through. This gap presents some investors with an interesting opportunity though, as a potential trading strategy can be applied to this phenomenon.

Investors can go long in the to-be acquired company, and then short the acquiring firm. Then, when the deal goes through, the acquired company’s stock should increase to the full deal price, giving investors a nice profit.

While this approach may not exactly be ‘arbitrage’ in the traditional sense, as there is definitely a risk of loss if the deal doesn’t go through, it is generally speaking a lower risk strategy, especially when applied across a number of companies at the same time (see Two ETFs for the Muddle Through Economy).

Why now?

This approach could be in focus now more than ever thanks to the low correlation that this technique has with overall markets. Merger and acquisition deal companies usually move relatively independent of other stocks, as being taken over generally trumps all other issues (see Food ETFs in Focus on Deal Wave).

Plus, there have been a ton of announced deals lately, so there are a number of potential companies to apply this technique towards. This makes a basket, diversified approach very easy to accomplish, allowing investors to spread the risk around a number of mergers and acquisitions instead of just focusing on one or two.

How to play with ETFs

Fortunately for investors seeking to apply this approach to their portfolios, there are a number of merger arbitrage ETFs on the market. This will allow investors to avoid the worries of shorting stocks, while at the same time quickly and cheaply establishing basket exposure across a host of firms in various sectors (see Time for a Merger Arbitrage ETF?).

Below, we highlight three merger arbitrage ETFs currently trading in the market, any of which could make for compelling options for investors seeking to implement this low correlated strategy to their portfolios during this rocky market environment:

IQ Merger Arbitrage ETF (MNA)

The first ETF in this space tracks the IQ Merger Arbitrage Index, a broad benchmark of companies for which there has been a public announcement of a takeover. The goal of the ETF is to generate returns that are representative of global merger arbitrage activity, while also including short exposure to global equities as a type of market hedge.

According to the most recent fact sheet, the fund has roughly 35 holdings in its basket, while top holdings appear to be in Life Technologies, NYSE Euronext, and Dell. Costs come in at 76 basis points a year, while the index has a decent dividend yield of roughly 1.5%.

The fund has seen a decent performance during this latest bout of instability, as the ETF has added about 2.5% in the past month. This compares favorably to the S&P 500’s 22 basis point loss during the same time frame, suggesting that MNA has held up quite well.

ProShares Merger ETF (MRGR)

Another option for investors in this corner of the market is MRGR, an ETF from ProShares that tracks the S&P Merger Arbitrage Index. This benchmark looks to hold up to 40 publicly announced deals within developed market countries, keeping about 3% in each company.

Top holdings in this fund include NYX, HCBK, and ELN, while the market cap level skews towards small and micro cap securities. From a sector perspective, consumer discretionary firms take the biggest spot, followed by technology and financials to round out the top three (see ProShares Launches Merger Arbitrage ETF).

This ETF has also outperformed the S&P 500, adding about 1.15% in the past one month time frame. The fund is also barely cheaper than its MNA counterpart—beating it by one basis point—though trading volumes are extremely light.

Credit Suisse Merger Arbitrage Index ETN (CSMA)

For an exchange-traded note approach, investors have CSMA at their disposal, a product that tracks the Credit Suisse Merger Arbitrage Liquid Index. This benchmark has several dozen companies, focusing on liquid firms that see a positive acquisition premium that is an offer for substantially all shares outstanding of the target.

Some of the current top holdings include BMC, LIFE, and S on the long side, while for short exposure, MTB, ODP, and ACT make up some of the biggest allocations.

This has actually been the best performer of the group, adding about 3.2% in the past month. However, this product is a bit pricey with fees coming in over 1% a year in total. Plus volumes are extremely light here as well, suggesting that it may be a difficult choice for those seeking to make a quick play on the space (also read Three Biggest Mistakes of ETF Investing). 

(Note that all three have light trading volumes and that bid ask spreads may be wide at times. As a result, it is important to use limit orders if you are thinking about trading any of these ETFs.)

Bottom Line

This isn’t the sexiest strategy out there and it will probably underperform in bull market environments. However, in sluggish market conditions or when global fears are elevated, this could be an uncorrelated way to approach investing.

There will always be mergers and acquisitions, and thus there will always be ‘arbitrage’ opportunities on these deals. While investors can certainly try to do this strategy on their own, ETFs are clearly more diversified options that could be cheaper in the long run (thanks to all the trading cost issues being removed).

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