With a new administration in the White House, the expectation for change is immense. Throughout his campaign, Trump promised a more business-friendly government, and on his first day in the White House, he reiterated that promise, telling corporate leaders he planned to cut government regulations that hinder their businesses by at least 75 percent, and to “massively” cut taxes. And while it may be easy to surmise that such a promise would most certainly drive stock prices higher, Trump also has a proven propensity to send midnight Tweets that cause market swings in the opposite direction. His January 18 Tweet that the dollar was “too strong” propelled the dollar to a seven-week low against the yen—and it certainly wasn’t the first time he’s wreaked havoc on the market in 140 characters or less. In this environment, even professional investors can get a little spooked.
With this reality as a backdrop, one way to potentially insulate your portfolio is to become a merger arbitrageur. And while that may sound daunting (the advisors are few and far between who choose to spend their free time studying the vast landscape of current mergers and acquisitions), there is a way to realize the benefits of merger arbitrage without the homework and, even more importantly, without the potential tax consequences. Doing so can ease the nerves of those clients who tend to panic every time the market takes a downward turn. But before we go there, it’s important to understand why mergers and acquisitions (M&A) make sense as a market hedge in the first place.
Merger arbitrage has been used to combat volatile equity markets for decades, and for good reason. Like other alternative investments, M&A returns are typically uncorrelated with the equities market. When unforeseen shocks hit the market, these investments can help manage the level of volatility within a portfolio. Additionally, the risk associated with M&A is relatively low due to the fact that the strategy is dependent not on stock valuations, but on the completion rate of corporate deals. The only significant slump in M&A activity in the past decade was in 2009, at the peak of the financial crisis. Even then, the number of announced deals took less than six months to recover, with ample deal flows returning long before the equities market had fully recovered. And while there have been times when the DOJ’s anti-trust regulations have temporarily impacted specific industries (remember the American Airlines/US Air debacle?) or the Treasury rules on tax inversions have targeted specific deals (think about Allergan and Pfizer), those isolated events tend to have a short-lived impact on returns in the merger arbitrage space.
Assuming the new administration lives up to its promise to create a business-friendly environment by cutting regulations and reducing corporate taxes, the likelihood of the DOJ becoming overzealous and restricting deal-making activities is pretty low. Also, with a likely improved business environment and lower corporate tax rate, there should be fewer tax inversion deals. This is important from a merger arbitrage perspective, since the more deals that are actually closed, the higher the returns. (Think of the process like selling a house: having the property in escrow shows promising activity, but until the deal is closed, the money doesn’t hit your bank account.) With the prospect of less government interference comes the potential for more closed deals, both of which are advantageous to M&A strategies.
Even with the potential for an increase in M&A returns, one of the challenges of merger arbitrage is managing the capital gains tax associated with the sheer volume of turnover. Experienced merger arbitrageurs know how to play this game well. For advisors who want to gain the benefits of merger arbitrage without becoming experts in M&A, one solution may be a merger arbitrage ETF. Using an ETF, M&A investments are contained within the structure of the fund, giving investors access to these investments while also providing the potential for competitive pre-tax and post-tax advantages that aren’t available using a traditional merger arbitrage approach.
It’s true that Trump’s comments have the potential to throw the market into a tailspin. Whether he’s talking about repealing Obamacare (which can make healthcare stocks soar) or criticizing the strength of the dollar (which can make the value of the dollar plummet), his words can make the market go wild. By adding greater diversity within your equity portfolio, merger arbitrage can help smooth out the peaks and troughs of a volatile market—no matter what Trump Tweets tomorrow.
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