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Some investors might have thought self-help guru W. Clement
Stone had hedge funds in mind when he said, "Events tend to
recur in cycles."
Event driven ((
)) funds, in fact, have been some of this year's best performers, a
cycle their investors certainly hope becomes repetitive. Portfolios
pursuing EDstrategies attempt to profit from mergers,
restructurings, shareholder buybacks, tender offers, debt exchanges
and private security offerings. According to Hedge FundResearch ,
Inc., ED portfolios collectively gained 5 percent for the year
through September, a definite reversal of fortunes over the nearly
5 percent loss posted for the comparable period last year.
With signs of a recovery flickering, investors and advisors now
wonder if the level of corporate transactions is likely to rise in
the coming year. An expansive economy would likely broaden the
opportunity set for ED funds. To see how, you first need to
appreciate the manifold strategies within the ED universe.
The ED category includes funds specializing in merger arbitrage,
distressed restructurings, private issue/Regulation D offerings,
credit arbitrage and special situations.
portfolios trade in the equity and equity-related instruments of
companies engaged in corporate transactions. Merger arbitrage funds
exploit announced merger and acquisition (M&A) deals, typically
with limited or no exposure to pre- and post-date situations.
Simply put, these funds are quite opportunistic -- they hold
positions only as long as M&A deals are pending; once a deal is
completed or broken, they're out. These funds may engage in
international transactions which incorporate hedges to dampen
foreign exchange exposure. Additional hedging activity, typically
through derivatives such as swaps or futures, may be employed to
suppress systematic market risk. Merger arbitrage funds typically
have more than 75 percent of their portfolios weighted in announced
transactions with the balance held in cash, cash equivalents and
funds make plays on corporate fixed-income instruments, primarily
the corporate credits of companies trading at significant discounts
to their value at issuance or par value at maturity. These
discounts often develop as a result of actual or anticipated
bankruptcy proceedings. Portfolio runners may be actively involved
with the management of the affected companies, most often by
sitting on the creditors' committees that negotiate the exchange of
securities for alternative obligations such as debt and equity
swaps or hybrid securities.
Private Issue/Regulation D
strategies concentrate on the equity and equity-related instruments
of companies which are primarily private and illiquid in nature.
Positions are often undertaken to realize aninvestment premium for
holding the securities until a catalytic event, such as a security
issuance or emergence from bankruptcy, occurs. These funds
typically maintain more than half of their portfolios in private
securities, including Reg. D or PIPE (private investments in
publicequities ) issues.
Less common are strategies involving
." Credit arbitrage funds attempt to isolate attractive
opportunities in corporate fixed-income securities, including
senior and subordinated obligations, bank debt and other credits.
Positions, by virtue of hedging, are often structured with little
or no broad credit market exposure and are geared to appreciate as
the issuer's creditworthiness improves.
Special situations portfolios trade in equity and equity-related
instruments of companies engaged in security issuance or
repurchases, spin-offs, asset sales and other catalyst-sparked
situations. In contrast to distressed restructuring strategies,
special situation funds employ more equity but may still
incorporate some debt exposure. In general, special situation
portfolios tend to focus on post-bankruptcy equity exposure and the
end plays of corporate restructurings.
Managers of activist funds attempt to obtain representation on a
company's board of directors to influence the firm's policies or
strategic direction. By advocating asset sales, corporate
divestitures, dividend or share buybacks, and changes in
management, activist managers hope to drive up the value of their
equity and equity-related positions.
Broadly, event driven strategies generated modestly positive
performance in recent months as macro-related disturbances, such as
the impact of the Euro crisis, subsided. Still, managers are
keeping exposures at fairly conservative levels and maintaining
defensive postures. Of primary importance to portfolio managers now
is liquidity maintenance. In this low-rate environment, that's
tended to dampen returns. With portfolio positioning generally
stable, selling into this summer's strength as securities achieved
targeted price levels further raised fund cash levels.
Transaction volume for global M&A activity has fallen off
recently, negatively impacting merger arbitrage portfolios. The
deal environment is muted because corporate decision makers are
delaying actions as they look for further signs of market stability
and certainty. Still, support for an M&A rebound exists in the
medium- to long-term, so portfolio runners are positioning their
funds to be long on a number of event and pre-event situations.
Distressed and restructuring situations particularly have been
well supported by the broad market's overall positive tone.
Activist funds, as well, have benefited from equity- and
credit-sensitive exposures as they participated in transformational
deals, breakups and divestitures.
Credit strategies, meantime, have exhibited strength in light of
continued supportive technical strength and increased risk
sentiment. Positions trading at or near target levels were closed
to capture gains asmarkets headed into the usually thinly-traded
summer further building up cash hoards.
So what kind of opportunities motivate ED fund managers to sock
away all that cash?
Shakespeare tells us that the "past is prologue," but we must
temper that with the regulators' admonition that past performance
doesn't guarantee future results. That said, a look at key ED key
strategies' performance gives us an idea of what these funds can do
relative to the general market (see Chart 1 and Table 1).
Over a 15-year horizon, ED strategies have outperformed the
broad stock market with little correlation and much less
volatility. They've all earned positive alpha. Note, however, that
ED funds don't always hit home runs -- all except private
issue/Regulation D portfolios underperformed the S&P 500 from
1996 until early 2001. ED managers just got on base often enough to
build up a substantial lead.
Enticing as this may be, not everyone is suited to invest in the
rarefied atmosphere of hedge funds. There are, however, some
exchange-traded products that permit investors to gain access to
the ED space. Unfortunately, they presently ply just only one
strategy -- merger arbitrage.
[[MNA]] - IQ Hedge Merger ArbitrageETF -
The index tracked by this fund represents investment in global
companies for which there has been a public announcement of a
takeover. MNA only buys the shares of acquisition targets; it
doesn't sell shares short. However, the fund does undertake short
exposure to global equities -- in the form of futures contracts and
swap agreements -- as a partial market hedge.
The fund's long positions in its top ten issues, together with
its cash holdings, constitute more than two-thirds of the portfolio
If there's an insufficient number of target companies in which
to invest or if there's insufficient liquidity to accommodate
investment per index rules, the fund's available cash is invested
in fixed-income securities. At last look, the portfolio's cash and
cash equivalent position was its second-largest long holding at 7.7
The notional value of short hedge positions in S&P 500 and
MSCI EAFE futures totals 16.5 percent of the portfolio's
During the most recent fiscal year, the fund's portfolio
turnover rate was 365 percent of the average value of its
portfolio. The fund's high turnover rate increases transaction
costs and lowers its return.
The Credit Suisse Merger Arbitrage Index (Net) ETN
is a non-interest-bearing medium-term obligation of A+ rated Credit
Suisse AG and is linked to the performance of the Credit Suisse
Merger Arbitrage Liquid Index (Net).
The note's underlying index is a quantitative benchmark built on a
dynamic basket of securities held long and short that reflects
publicly announced merger and acquisition transactions. The index
attempts to capture the spread between the price at which the stock
of the target company trades after an acquisition proposal is
announced and the price which the acquiring company has offered to
pay for the target. The spread normally arises from the uncertainty
that the announced merger or acquisition will close, and if it
closes, that the transaction will take place at the proposed terms.
In successful transactions, the spread approaches zero by the
transaction closing date. The size of the spread itself depends on
the perceived risk of the deal closing, as well as the length of
time expected until completion.
If the acquirer proposes to buy the target in a cash-for-stock
transaction, the index reflects a long position in the target stock
but no position in the acquirer's shares. If the acquirer instead
proposes to buy the target by exchanging its own stock for the
target's shares or a combination of cash and its own stock, the
index reflects a long position in the target stock and a
proportional short position in the acquirer's shares at the
transaction's exchange ratio.
The index methodology includes a number of constraints that
narrows the deal universe. First, there's geography: The deals
include only North American and Western European mergers and
acquisitions that meet certain liquidity and arbitrage criteria.
Additionally, the acquirer's stock must be "easy to borrow."
Turnover is controlled through the index rebalancing procedures.
Deals are also asset-weighted and capped (the maximum weight of an
individual issue is 7.5 percent); short exposure is also
Presently, four of the index's long positions, including the two
weightiest stocks, are paired against short sales. Coventry Health
) opposite is Aetna Inc. (
) and Hudson City Bancorp (
) is set against M&T Bank Corp. (
). The total weight of short stock positions in the index is
currently -13.4 percent. Cash currently represents the largest
component of the index.
The Leveraged Credit Suisse Merger Arbitrage Liquid Index
is essentially a turbocharged version of its CSMA sibling. CSMB
provides 200 percent exposure to changes in the monthly closing
level of CSMA's index.
Besides the leverage factor, there's another essential
difference between the CSMA and CSMB notes. The CSMA notes mature
in October 2020; the leveraged paper winds down in March 2031.
Because of CSMB's base and compounding, the note will not track
as merely a double dose of CSMA. Over time, the relationship of the
two ETNs tends, in fact, to break down.
Since the CSMB notes rebalance their theoretical exposure on a
monthly basis, they increase exposure in response to that month's
gains or reduce exposure in response to that month's losses.
Rebalancing can impair the ETN's performance if the index
experiences volatility from month to month. At higher ranges of
volatility, there's a significant chance of loss even if the
performance of the index is flat. You can see how the relationship
between CSMA and CSMB vacillates in Chart 2.
Clearly, the recent performance of the merger arbitrage products
has been less than stellar. But look back at their 15-year history
in Chart 1 and you'll see the strategy underperformed the overall
market for some time before moving to a premium. The eventual
outperformance was facilitated largely by the funds' low
volatility. Largely, merger arbitrage funds didn't give up their
gains as readily as the broad market.
What investors and their advisors have to ponder now is
theprospect for a step-up in economic activity. Corporate
executives are likely to increase M&A activity and security
issuance when the economy shows definitive signs of sustainable
growth. Event driven funds tend to thrive in such resurgent
A clue about the prospects for a turnaround is the volume of new
ED products in registration. Presently three new exchange-traded
funds -- one activist, one tracking distressed securities and yet
another merger arbitrage portfolio -- await clearance from the SEC.
Take what you want from that. It's not a lot, but it's not zero
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