By Salvatore Bruno, Chief Investment Officer and Managing Director, IndexIQ
Not all risks are created equal; looking at merger arbitrage through a managed risk lens
That risk and reward are related is a key tenet of Modern Portfolio Theory (MPT) and portfolio construction. To achieve a return above the risk-free rate, usually figured as the yield on a 3-month U.S. Treasury bill, you have to assume some level of risk, but it’s important for investors to minimize exposure to those risks not associated with the expectation of positive returns and to manage the remaining risks to better the chances of seeing some of the “rewards” from the risk/reward relationship.
Looking at merger-arbitrage strategies like that employed by our fund, the IQ Merger Arbitrage ETF (MNA), we can break those risks into two categories:
- Deal-specific risk, and
- Stock price risk of the acquirer from deals being financed by stock (i.e. the acquirer’s stock price declines, negatively impacting the value of the transaction).
Merger-arbitrage funds like MNA seek to take advantage of the positive difference in the announced price of a transaction and the current price. A recent example of this as it applies to MNA is the Meet Group (MEET), which received an all-cash offer of $6.30 per share on March 5th. As deal completion risk rose during the early stages of the Covid 19 shutdown, the deal premium widened and the price of MEET fell. MNA added MEET during the April rebalance at $5.92. The deal subsequently closed on Sept 8th at the original offer price of $6.30 and the fund made over 6% on the transaction.
But not every deal works out, creating vulnerability. The risk: when a transaction falls apart, the stock price of the target usually declines.
This can be mitigated by