The cost effective way to merger arbitrageContributor Yazann Romahi
The hedge fund landscape is changing. Recent research has made it clear that a significant component of the returns from the main hedge fund styles are generated not only by fund managers’ skill, but as compensation for taking on some form of risks itself, or “beta.” The process is analogous to that of equity index fund investing, but instead of a large universe of stocks, investors hold a large universe of merger deals. The discovery is increasingly making it possible to attain hedge-fund-like returns, and diversification, through liquid, low-cost funds.
Merger arbitrage, a well-established hedge fund style, illustrates this possibility.
Traditionally, an active merger arbitrage manager will invest in a company being acquired, post the announcement of the merger but before the merger actually takes place while shorting the offering company. The premise is to capture the premium between the offer price and the prevailing price of the target stock. If the deal completes, the investor realizes a small return; if it fails, the investor faces potentially a large loss as the target stock drops back to the pre-offer price. The active manager would argue that skill is the key in determining the subset of deals to buy that are likeliest to complete.
Academic literature, on the other hand, finds that the risk premium exists explicitly to compensate investors for the risk of deal failure.1 Another way to look at this: the risk premium is as a form of insurance premium. The merger arb fund offers liquidity to shareholders who want to sell to realize the gains they have already made and protect themselves if the deal fails to close.
The literature argues that the return exists since the arbitrageur is taking on this negative skew risk. This risk can be reduced by diversifying across a large number of deals, significantly reducing the impact of any one deal failing to close. The “beta” of merger arbitrage evidently came from capturing the risk premium in the aggregate of all investable deals --just as equity beta is created by holding a large universe of stocks --and shorting appropriately so that the fund is purely invested in arbitrage and unaffected by the broad equity markets. We believe that merger arbitrage deals' beta may explain a large portion of the return.
Capturing the premium isn’t straightforward for funds. They must short stock deals and rebalance portfolios as deals are announced and completed. The strategy exhibits some residual equity sensitivity, so funds can’t be entirely market-neutral—risk spreads widen in periods of market stress. Yet because the merger universe is relatively limited (typically, to 50 to 90 names at any one time), leaving little possible dispersion among different managers, returns to the average manger are driven—not surprisingly—by systematic exposure to a verifiable merger arbitrage beta.
In short, research makes it clear that cost-effective alternative beta funds are especially well-suited for gaining exposure to the merger arb strategy of hedge fund investing.
1M. Mitchell and T. Pulvino, “Characteristics of risk and return in risk arbitrage,” The Journal of Finance, 56 (2001): 2135– 2175.
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