Research

Merger Arbitrage Hedge Funds Strategy Profile

Corporate events such as mergers and acquisitions (M&A) and company spinoffs provide opportunities for merger arbitrage hedge funds to capitalise on pricing inefficiencies prior to the completion of a transaction. Before acquisition, the price of the share of a target company is usually traded at a discounted price, creating a potential opportunity for merger arbitrageurs to reap gains once the transaction is complete. However, much of the opportunities within the merger arbitrage space lies in the health of M&A activity as well as other factors which would motivate (or de-motivate) the successful transaction of an M&A deal. For instance, the Pfizer/Allergan M&A deal was threatened by US regulatory challenges and this led to the abandonment of the deal. Other than regulatory challenges, the outlook of the global economy as well as business sentiments play an integral role in sustaining the appetite for corporate activity by conglomerates.

Figure 1 shows the performance of merger arbitrage hedge funds versus market index and other investment vehicles since December 2006. Over the period analysed, merger arbitrage hedge funds gained 61.96% outperforming the S&P Merger Arbitrage Hedge Fund Index, while underperforming the Eurekahedge Hedge Fund Index and the Eurekahedge Long/Short Equities Hedge Fund Index which was up 83.06% and 77.02% respectively. Over the past year, merger arbitrage hedge funds have outperformed the Eurekahedge Hedge Fund Index and the Eurekahedge Long/Short Equities Hedge Fund Index with merger arbitrage hedge funds gaining 5.99% while the Eurekahedge Hedge Fund Index gained 4.50%. Long/short equities counterparts were up 3.94% over the same period of time.

Figure 1: Performance of merger arbitrage hedge funds versus market index and other investment vehicles
Performance of merger arbitrage hedge funds versus market index and other investment vehicles


In Table 1, key statistics for the performance of merger arbitrage hedge funds against market index and other investment vehicles are displayed. Key takeaways include:

  1. Barring 2011, merger arbitrage hedge funds have posted positive annual returns up until 2017 year-to-date. In 2016 annual year, merger arbitrage hedge funds beat the Eurekahedge Hedge Fund Index and the Eurekahedge Long/Short Equities Hedge Fund Index as well as the S&P Merger Arbitrage Index.

  2. Merger arbitrage hedge funds posted positive three and five year Sharpe ratio of 0.58 and 0.82 respectively though underperforming global peers and long/short equities peers over both periods.

  3. Both three and five year volatility levels for merger arbitrage hedge funds are lower compared to long/short equities hedge funds and somewhat comparable to that of global hedge funds.

  4. Over the three and five year period, the annualised returns of merger arbitrage hedge funds underperformed that of Eurekahedge Hedge Fund Index and the Eurekahedge Long/Short Equities Hedge Fund Index, however volatility of merger arbitrage hedge funds are much lower than their long/short equity counterparts for both the three and five year period.

Table 1: Performance of merger arbitrage hedge funds versus market index and other investment vehicles

Eurekahedge Merger Arbitrage Hedge Fund Index
Eurekahedge Hedge Fund Index
Eurekahedge Long/Short Equities Hedge Fund Index
S&P Merger Arbitrage Index
2011
(4.37%)
(1.75%)
(5.93%)
(0.84%)
2012
3.82%
7.38%
8.57%
6.96%
2013
7.05%
9.29%
16.12%
(2.83%)
2014
1.12%
4.97%
3.71%
(1.19%)
2015
1.14%
1.97%
3.25%
1.29%
2016
5.99%
4.50%
3.94%
(0.39%)
2017 year-to-date
1.99%
2.35%
3.79%
(0.43%)
5 year annualised returns
3.59%
5.21%
6.51%
(0.26%)
5 year annualised volatility
3.16%
3.03%
4.99%
3.15%
5 year Sharpe Ratio (RFR = 1%)
0.82
1.39
1.10
(0.40)
3 year annualised returns
2.96%
4.19%
4.43%
(0.18%)
3 year annualised volatility
3.39%
2.91%
4.81%
2.78%
3 year Sharpe Ratio (RFR = 1%)
0.58
1.10
0.71
(0.42)

Source: Eurekahedge


Table 2 shows the correlation matrix of merger arbitrage hedge funds versus market index and other investment vehicles with high correlations between global hedge fund peers as well as long/short equities hedge fund counterparts as underlying asset exposure for funds within the merger arbitrage sphere and those in long/short equities are similar. Merger arbitrage funds display slightly weaker correlations to the S&P Merger Arbitrage Index1, perhaps capturing some of the underlying M&A deals these merger arbitrage hedge funds have exposure to.

Table 2: Correlation matrix
Eurekahedge Merger Arbitrage Hedge Funds Correlation matrix


In Figure 2, the 12-month rolling volatility of merger arbitrage hedge funds against the market index and other investment vehicles is displayed. Long/short equities hedge funds showed a higher 12-month rolling volatility over the period analysed whereas the volatility level of merger arbitrage hedge funds is in the lower range. The 12-month rolling volatility for the period ending 2016 showed that merger arbitrage hedge funds posted volatility of 3.05% whereas long/short equities hedge funds posted volatility of 5.65% over the same period.

Figure 2: 12-month rolling volatility of merger arbitrage hedge funds vs. market index and other investment vehicles
Eurekahedge merger arbitrage hedge funds 12-month rolling volatility vs market index and other investment vehicles

Table 3 below shows the performance of merger arbitrage hedge funds during key market events. Key takeaways include:

  1. Merger arbitrage hedge funds have posted positive returns in four out of 11 key market events identified. This is in comparison to long/short equities hedge funds which were positive for three out of the 11 key market events and the S&P Merger Arbitrage Index which were positive for seven out of 11 events identified.
  2. With regards to idiosyncratic risk events such as Trump and Brexit, merger arbitrage hedge funds gained 0.91% and lost 0.43% respectively outperforming the S&P Merger Arbitrage Index and the Eurekahedge Long/Short Equities Hedge Fund Index respectively on both occasions.
  3. With the underlying asset class similar between long/short equities hedge funds and those employing merger arbitrage strategies, it is worthy to note that merger arbitrage hedge funds have outperformed their long/short equities counterparts in 8 out of 11 key market events.

Table 3: Returns during key market events

Date
Event
Eurekahedge Merger Arbitrage Hedge Fund Index
Eurekahedge Hedge Fund Index
Eurekahedge Long/Short Equities Hedge Fund Index
S&P Merger Arbitrage Index
Nov 16
Trump Win
0.91%
0.27%
0.62%
0.50%

Jun 16

Brexit
(0.43%)
0.31%
(0.63%)
(0.59%)
Feb 16
Oil Price Dip/China growth concerns
0.44%
0.02%
(0.72%)
1.22%
Jan 16
Oil Price Dip/China growth concerns
(1.05%)
(1.74%)
(3.81%)
0.53%
Aug 15
China Equity Crash
(1.57%)
(1.91%)
(2.70%)
0.68%
Jul 15
China Equity Crash
(0.94%)
(0.05%)
(0.75%)
0.95%
Jun 15
Greek referendum
(1.27%)
(1.14%)
(1.01%)
(0.74%)
Jan 15
Swiss Franc De-pegging
0.16%
0.78%
0.04%
0.80%
Sep 14
Oil Price Dip
(0.78%)
(0.21%)
(1.13%)
(0.09%)
Jun 13
Taper Tantrum
(0.92%)
(1.32%)
(1.48%)
(1.04%)
May 13
Taper Tantrum
0.72%
0.47%
1.59%
0.12%

Source: Eurekahedge


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Footnote
1 The S&P Merger Arbitrage Index is comprised of stocks currently involved in pending mergers. At any given time, a maximum of 40 companies that are currently targets in merger deals are represented in the index in long positions and a maximum of 40 companies that are currently acquirers for the same stock merger deals are represented in short positions.
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