For investors, the growth of the ETF industry has certainly been a blessing. Aside from accessing equities and bonds for dirt cheap, regular retail investors now have the opportunity to gain access to strategies that were once either too expensive or hard to reach. Historically, alternative assets have been very costly and almost impossible for the little guy to gain exposure to. With the ETF boom still going strong, new products have allowed individual retail investors the ability to access hedge funds, long-short strategies, 130/30 tactics and other areas of the market previously off-limits. Anyone with a brokerage account can now channel their own inner hedge fund manager [Download How To Pick The Right ETF Every Time].
One of more interesting opportunities for retail investors than can be tapped via exchange-traded funds lies within the absolute return strategy of merger arbitrage.
At its core, merger arbitrage–sometimes called risk arbitrage–is when investors seek to profit from the spread that occurs when an acquisition is announced and the final purchase price is set. Typically, when a buy-out deal is announced, there is some risk that the merger deal will not close on time, or if at all. Because of this slight uncertainty, the target company’s stock will typically sell at a discount to the price that the combined company will have when the merger is closed. This discrepancy is the arbitrageur’s profit [Download 101 ETF Lessons Every Financial Advisor Should Learn].
An offshoot of merger arbitrage also involves shorting shares of the acquiring company. Generally, the firms doing the buying will often see their share prices fall when a deal is announced. This produces a bigger spread for the investor.
For example, company A offers $20 to buy firm B. B’s stock price then falls to $19.50. A merger arbitrage investor will then buy company B’s stock and, when the deal closes, pocket the 50 cents. While that might not seem like a lot of money, doing the strategy over several deals produces steady returns that are not correlated to any sort of market or business cycle. The best merger arbitrage investors are able to generate 5-7% returns year-in and year-out–even in down markets [see also Favorite ETF Positions For 5 Super Investors].
The obvious drawback is if the deal fails to close or get approved, the target firm’s shares could plummet. This leaves the arbitrageur holding the bag and could result in big losses.
Gauging an individual deal’s chances is a difficult and time-consuming endeavor. This is exactly why ETFs can be the perfect way to gain exposure to absolute strategy. Here’s how to play it:
Debuting in October 2010, the Credit Suisse Merger Arbitrage Liquid Index (CSMA) provides exposure to the investment strategy by taking long and short positions in announced deals within the United States, Canada and Western Europe. The ETN strictly focuses on firms involved in a deal, rather than buy-out potential. This means it provides a “true” merger arbitrage option for a portfolio.
Another appealing aspect of this fund is its relatively low cost; CSMA charges a mere 0.55%, making it the cheapest offering among the merger arbitrage ETFs [see Cheapskate Hedge Fund ETFdb Portfolio].
For those investors looking for a little more oomph from their M&A bets, Credit Suisse also offers a leveraged version, the Credit Suisse Leveraged Merger Arbitrage Liquid Index ETN (CSMB). This fund tracks the same index as CSMA at twice the daily performance.
IQ Merger Arbitrage ETF (MNA, A-)
The IQ Merger Arbitrage ETF (MNA) is the grandfather fund in the sector, debuting in 2009. Like CSMA/CSMB, MNA’s underlying index provides exposure to domestic as well as global companies that have recently announced takeovers by another company. As a hedge, the fund will also take short positions in certain acquiring company’s stocks.
The fund, however, is slightly more expensive than its competitor, with its expense ratio coming in at 0.76% [see also Ultimate Guide To IndexIQ Hedge Multi-Strategy Tracker ETF (QAI)].
ProShares Merger ETF (MRGR, n/a)
ProShares is mostly known by investors for its leveraged ETF products. However, the firm has been making strides into the strategy-based market; ProShares’s latest is the ProShares Merger ETF (MRGR).
This fund tracks the S&P Merger Arbitrage Index and like the other funds on this list, it seeks to capitalize on the spread between stock prices of a target company after an M&A deal is proposed compared to the offering company. Like the ETFs we’ve been discussing, the ProShares fund will also short the acquiring company’s shares .
Since this is a relatively new fund–it started trading this past December–performance data versus its peers is not available. However, the name recognition of its index provider could give this ETF the edge in gathering assets and tradability versus the other ETFs on this list. Expenses currently run 0.75%.
Disclosure: No positions at time of writing.