Merger arbitrage is a specialized trading strategy that seeks to capitalize on price differentials between a target company’s stock price and the offer price during a merger or acquisition. This strategy involves taking advantage of market inefficiencies created by the uncertainty surrounding such corporate events. But is it an effective strategy for trading? Does the reward outweigh the risks? Let’s look at a merger arbitrage trading strategy.
In this article, we will delve into the intricacies of merger arbitrage, explore its key components, and backtest the strategy to determine its profitability.
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Understanding Merger Arbitrage
Merger arbitrage revolves around exploiting price disparities that arise when a merger or acquisition is announced. The primary goal of a merger arbitrage is to capture the spread between the current market price of the target company’s shares and the price offered in the acquisition deal.
This strategy operates on the premise that the market may not accurately reflect the true value of the target company during the acquisition process. If the deal goes through, the spread will narrow, and the more likely it is to happen, the closer it gets when it approaches the merger date.
If the risk doesn’t get through, the loss might be huge.
One key aspect of understanding merger arbitrage lies in comprehending the mechanics of a merger. When a company announces its intention to acquire another, it often offers a premium over the current market price to entice shareholders to sell their shares. This premium is where arbitrageurs see an opportunity. They purchase shares of the target company at the current market price, anticipating that, upon completion of the merger, the stock price will converge with the offered acquisition price.
Successful merger arbitrage requires a keen analysis of the deal’s likelihood of completion and the potential for regulatory hurdles. Investors need to assess the regulatory environment, as government bodies may scrutinize mergers for potential antitrust concerns.
Moreover, understanding the terms and conditions of the deal, including any contingencies or potential roadblocks, is crucial for effective arbitrage.
Risk management is a critical component of a merger arbitrage strategy. Unforeseen events, such as regulatory challenges, financing issues, or changes in market conditions, can impact the success of the arbitrage play. Diligent monitoring of the deal’s progress and the ability to react swiftly to new information are paramount.
Investors should also consider the broader economic landscape and market conditions when engaging in merger arbitrage. Economic downturns or periods of increased market volatility can influence the success of arbitrage plays. Additionally, liquidity in the target company’s stock is a vital consideration, as low liquidity can make it challenging to enter or exit positions without impacting prices.
Merger arbitrage is not rocket science, but it requires careful evaluation and continual monitoring to navigate successfully. However, how profitable is this strategy?
Merger Arbitrage Trading Strategy – Backtest And Results
To test the profitability of merger arbitrage strategies, we decided to examine some of the ETFs and Mutual Funds available to investors. The first one is the IQ Merger Arbitrage ETF.
Here is its performance since its inception in 2010:
As you can see, the difference is huge. The CAGR of the IQ Merger Arbitrage ETF is 2.73%, while the S&P 500 is 18.52%. However, the volatility is less than half: 7.83 vs. 17.27 for SPY.
Another mutual fund that employs this type of strategy is The Merger Fund. Here is the equity curve since 2013:
A priori, it looks better than the previous ETF. The CAGR of the Merger Arbitrage fund is 4.46% vs. 17.37% for the SPY. Moreover, the volatility is much lower: 3.81 standard deviations vs. 17.29 for the market.
Merger arbitrage is a market-neutral trading strategy, thus the volatility is substantially lower.
Lastly, we can consider a study done by Verdad Research called Merger Arbitrage – Do Rsiky Deals Pay (we recommend following their weekly newsletter). The researchers constructed a database encompassing 835 deals occurring between 2000 and 2020.
Their methodology was straightforward: initiating a long position on the target five days after the deal announcement, and in cases where the acquirer paid with stock, concurrently establishing a short position on the acquirer based on the exchange ratio. These positions remained open until the deal concluded or fell through. The backtest is thus a 100% quantitative merger arbitrage trading strategy.
Approximately 40 deals per year met their specified criteria, with an 89% success rate in terms of closure. Successful deals yielded an average return of about 2.0%, while canceled deals resulted in a loss of 2.8%, culminating in a blended average return on long exposure of 1.5% if one were to engage in every merger.
The researchers believe that the positive returns generated from the long position in the target drove the overall performance for successfully closed deals, whereas the shorting of the acquirer (if applicable) tended to diminish returns, on average.
However, in instances where deals fell through, the short position on the acquirer contributed 110 basis points, a factor they posit served to mitigate the volatility of the return distribution.
Merger Arbitrage Trading Strategy – Conclusion
To sum up, merger arbitrage, when executed with a disciplined and well-researched approach, can offer investors a unique opportunity to generate returns regardless of broader market conditions- This is what we call uncorrelated results and is attractive for any portfolio.
However, success in this strategy requires a deep understanding of every deal, thus making this a pretty difficult strategy to execute if done qualitatively.