That risk and reward are related is a key tenet of Modern Portfolio Theory (MPT) and portfolio construction. To achieve a return above the risk-free rate, usually figured as the yield on a 3-month U.S. Treasury bill, you have to assume some level of risk, but it’s important for investors to minimize exposure to those risks not associated with the expectation of positive returns and to manage the remaining risks to better the chances of seeing some of the “rewards” from the risk/reward relationship.
Looking at merger-arbitrage strategies like that employed by our fund, the IQ Merger Arbitrage ETF (MNA), we can break those risks into two categories:
Merger-arbitrage funds like MNA seek to take advantage of the positive difference in the announced price of a transaction and the current price. A recent example of this as it applies to MNA is the Meet Group (MEET), which received an all-cash offer of $6.30 per share on March 5th. As deal completion risk rose during the early stages of the Covid 19 shutdown, the deal premium widened and the price of MEET fell. MNA added MEET during the April rebalance at $5.92. The deal subsequently closed on Sept 8th at the original offer price of $6.30 and the fund made over 6% on the transaction.
But not every deal works out, creating vulnerability. The risk: when a transaction falls apart, the stock price of the target usually declines.
This can be mitigated by portfolio diversification. The recent announcement by LVMH that it would not be completing the acquisition of Tiffany (TIF) is a case in point. TIF, a luxury consumer goods company, fell nearly 10% on the news and, with a weight of over 5% in MNA, knocked 50 basis points from performance. However, MNA (MNA-NAV) was up .14% for the day, with meaningfully positive contributions from other holdings such like Vivint, E-Trade and Noble Energy. The embodiment of this deal-specific risk, yes, but partially mitigated through diversification.
Merger-arbitrage funds like MNA seek to take advantage of the positive difference in the announced price of a transaction and the current price.
FactSet: Analysis period from January 1, 1998 – December 31, 2018. Past performance is no guarantee of future results. One cannot invest directly in an index. Sector hedge performance is represented by the S&P 500 sector and regional index returns.
A recent example of this is Vivint Solar (VSLR) which is being acquired by SunRun (RUN) in an all-stock deal. VSLR was added to the index in the August rebalance and has subsequently gone up 20%, largely reflecting a 21% gain in SUN. At the same time, the sector has declined -1%.
Because all-stock deals are currently prevalent, short positions, or hedge ratio, in the MNA index was over 50% as of 8/31/20, well above average, providing a hedge against the systemic risk described above.
By definition, any investment that offers a return in excess of the risk-free level involves some risk. But not all risks are the same. Some offer no expected upside and should be avoided, while others offer the potential to generate positive returns, but should be managed in a prudent fashion. Investors should understand where and how their risks are being assumed, and structure their portfolios accordingly.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Diversification cannot assure a profit or protect against loss in a declining market.
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This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
All holdings are provided as of month, day, year and are not indicative of future holdings or weightings. This information has been provided for informational purposes only and may change daily.
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.
Mean return, in securities analysis, is the expected value, of all the likely returns of investments comprising a portfolio.
Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk.
Nasdaq is used to refer to the Nasdaq Composite, an index of more than 3,000 stocks listed on the Nasdaq exchange The Nasdaq Composite contains all of the companies that trade on the Nasdaq. Most are technology and internet-related, but there are financial, consumer, biotech, and industrial companies as well.
The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
1. Source: Morningstar Data.
2. Source: JPM Municipal Markets Weekly.
3. Source: Citigroup Municipal Research.
4. Source: Citigroup Municipal Research.