Smooth Out Market Volatility With a Merger Arbitrage ETF

Remember the halcyon days of 2017? For advisors and investors, it was a fabulous year. The stock market maintained a steady climb skyward, and it delivered a nice, smooth ride to the top. In fact, if you look at the numbers, 2017 was the least volatile market since the mid-1960s. Of course, as many predicted, it was also the calm before the storm. It seemed the minute the calendar turned to 2018, the market began to swing, and over the past few months those swings have been so severe and frequent that it’s now poised to be the most volatile market since the financial crisis.

As an advisor, you understand that volatility is a given. If it’s not here today, it’s only a matter of time before it returns. And yet the dramatic shift from uncommonly low volatility to one that has everyone bracing for the next shakeup has many advisors searching for new strategies that can help smooth the ride for investors—especially clients who are nearing or in retirement and are concerned about large market swings that impact their portfolios in a shorter time horizon. One strategy that’s worth considering is that trusty old standby: merger arbitrage.

Merger arbitrage offers several potential benefits for investors, including increased diversification and the potential ability to dampen the impact of rising market volatility. Like other alternative investments, returns on mergers and acquisitions (M&A) are typically uncorrelated with the equities market—a characteristic that can help reduce the level of volatility within a portfolio. Plus, because the strategy is dependent on the completion rate of corporate deals—not on stock valuations—the market risks associated with securities is not an influential factor with M&A.

Looking at the IQ Merger Arbitrage Index (IQMNAT) , the only significant increase in M&A risk over the past decade was in 2009. And though that decline in prices mirrored the severe drop in the equities market that took place at the same time, M&A activity continued and in less than six months—long before the equities market reached pre-recession levels in mid 2012—investors were back to even. 1 The reason behind the temporary drawdown was simply a perception of deal risk that was reflected in prices.

So what exactly is merger arbitrage?

In short, merger arbitrage is a strategy that aims to profit from the price discrepancy between a stock’s price after the public announcement of a merger and the completion of the deal. Here’s how it works:

When a merger is announced, the stock price of the company being acquired has historically rallied in response to the offer to eventually settle at a level that the market deems appropriately prices the deal. Historically, that elevated stock price usually remains below the takeover bid price.

Related: The Key to Smarter Investing: Smart Beta ETFs

The price “discount” reflects the risk associated with the deal not actually closing—whether it’s due to problems obtaining shareholder approval or financing, regulatory issues, or other factors.

Historically, as the deal moves closer to completion and the risk of the deal falling through decreases, the discount narrows.

When purchasing the company being acquired below the target price, the investor is able to lock in the difference—or the spread—and realize a positive return on investment.

Source: The above is for illustrative purposes only, based on hypothetical events of an actual merger and acquisition.

Of course, as an advisor, studying the vast landscape of current mergers and acquisitions is probably the last thing you want to add to your already long to-do list. Luckily, there is a way to realize the benefits of merger arbitrage without the homework and, even more importantly, reducing the potential tax consequences. The answer is to use an exchange traded fund (ETF).

ETFs are popular because of the many important benefits they offer when investing in a variety of asset classes. For advisors who are ready to dive into the world of merger arbitrage, an ETF can be particularly valuable for three key reasons:

  • ETFs are more tax efficient. One of the challenges of a merger arbitrage strategy is managing the capital gains tax associated with the high volume of turnover. Using an ETF provides the advantages of the in-kind creation and redemption mechanism, which can significantly reduce capital gains exposure.
  • ETFs are less expensive. With lower fees and expenses than mutual funds and hedge funds, a merger arbitrage ETF can help keep costs as low as possible.
  • ETFs deliver competitive results: Because passive ETFs take human behavioral investment biases out of the picture, merger arbitrage ETFs have historically performed well compared to actively managed mutual funds that focus on the same strategy.
  • The odds are good that volatility isn’t going away anytime soon. Luckily, the same is true for global M&A activity. According to Mergermarket, M&A activity hit a 17-year high in the first quarter of 2018, including nearly 3,800 deals totaling $891 billion over the first three months of the year. And though improving corporate cash flows and greater clarity on the regulatory front don’t seem to helping the equities market as much as investors would hope, these factors are continuing to pump life into the M&A space. By using a merger arbitrage ETF, advisors can access M&A opportunities to not only support better short-term returns for their clients, but also to help smooth out the peaks and troughs of a volatile market in the months and years to come.

    Click here to learn more about the IndexIQ’s IQ Merger Arbitrage ETF (MNA).

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    1Source: IndexIQ, as of 4/1/2018,