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An ETF that profits from merger & acquisition activity

April 20, 2010 | About:
Back in August 2009, Walt Disney Co. (DIS) unveiled plans to acquire Marvel Entertainment (MVL) in a $4 billion cash/stock transaction. The deal valued Marvel at approximately $50 per share, a +30% premium to the $38.65 it fetched before the deal was announced.

Marvel shareholders were treated to an instant windfall as the stock shot up on the news. The shares settled at $48.37 when trading closed the next day -- a slight discount to the proposed offer price.

This happens quite often. There would be little sense in paying $50 for a stock that somebody else is planning to buy from you for $50 (unless you believe a higher bid is forthcoming). Plus, there's always the possibility that the deal might unravel -- regulatory concerns and shareholder backlash are two of the potential obstacles that can derail a takeover.

But in most cases, the deal is closed without a hitch -- so anyone that bought at $48 and change stands to make a quick profit once everything is finalized. This type of nickel and dime game is called arbitrage, and it happens practically every day in one form or another on Wall Street.

Arbitrageurs love these low-risk/low-reward opportunities. They'll take a free $1 here or $2 there all day long. If this concept sounds appealing, then you'll probably be interested in IndexIQ's Merger Arbitrage ETF (MNA) -- it's the first ETF designed to profit from merger & acquisition activity.

Launched in October 2009, the appropriately named MNA is an exchange-traded fund (ETF) that seeks to profit from price differentials like we saw with Marvel. In fact, Marvel was one of the fund's holdings, along with a couple dozen other companies that have found themselves in the cross-hairs of larger firms hunting for acquisition targets.

IndexIQ is relatively new on the scene, but it is tackling a niche that has been previously off-limits to most of us: Alternative investments. These strategic investments are employed by savvy hedge fund managers and can be highly profitable.

It's true that hedge funds use tactics that can backfire at times. And they have certainly received plenty of bad press. But make no mistake: they can also be extremely profitable. Why else would savvy billionaires write them such large checks?

Luckily, MNA is cut from a different cloth. This ETF isn't shooting for extraordinary gains, but rather easy ones. And we're not talking about potential takeover targets either, this fund holds confirmed deals that are just waiting for the "i's" to be dotted and the "t's" to be crossed. Unless something unexpected happens to sidetrack the deal, these opportunities almost always lead to sure profits in a short period of time.

The fund is a third-generation "rules-based" index -- essentially a hybrid between passive and active management. The index is reconstituted and rebalanced every 30 days to keep pace with the latest deals. Right now, technology, business services and energy make up the largest segments of the portfolio -- but those weightings will change with the M&A winds.The portfolio also has some short bets against major global indexes to hedge against market declines. Those positions, along with the fact that takeover targets march to the beat of their own drum, should limit downside exposure.

This new fund doesn't have much of a track record, but back-tested data shows the underlying index has outperformed the MSCI World Index since inception in October 2007 -- with less than half the annualized volatility.

I first spotlighted this fund in December 2009 for readers of my ETF Authority newsletter.

A few points I shared with my readers:

  • I think it's a safe bet the portfolio will lag a bit in runaway bull markets, considering the stock prices of the underlying holdings are capped by the terms of the takeover deals involved. But it should perform well under most other conditions, particularly down markets.
  • I expect to see high portfolio turnover as old deals are closed and new ones announced, so tax efficiency isn't a big selling point with this fund. However, low volatility is always welcome.
  • I gave the fund relatively strong marks in the valuation department, considering every stock in the portfolio is trading for less than what acquirers are willing to pay.
More wheeling and dealing means more potential arbitrage opportunities. On that front, shareholders have reason to be excited.

When the credit markets froze last year, M&A activity dried up. But cash is more plentiful now -- S&P 500 companies have more than $700 billion sitting on the books. And there are still plenty of bargains to be had despite rising stock prices. That combination will likely cause leveraged buyouts and other deals to begin heating up.

I'll be monitoring MNA for my closed-end fund rival Gabelli Global Deal (GDL). But for now, this new fund is worth looking into.

All in all, the fund looks to be an intriguing option for investors wanting to pocket an easy +6% to +8% return in an average year with little downside exposure.

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Nathan Slaughter

Editor: Market Advisor, The ETF Authority

About the author:

Street Authority
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