Merger arbitrage managers bet on the outcome of proposed company mergers, buying the stock of a target company or selling short the stock of the acquiring company – a strategy that, according to Capital Market Risk Advisors (CMRA), offers modest returns with low volatility.
But research by CMRA shows, the decrease in M&A activity has taken a toll on risk-adjusted returns and forced managers to hold their money in cash or in areas outside their specialties – actions that are often grounds for manager termination.
According to an analysis of major merger arbitrage hedge fund indices by Zurich Hedge Fund Indices between January 1998 and December 2000, these funds showed a Sharpe ratio, a measure that shows the level of return generated for every unit of risk taken, of 1.6%.
Sharpe ratios are calculated based on the difference between the average return and the benchmark return, divided by the standard deviation. A Sharpe ratio lower than 1% is considered poor performance.
However, CMRA notes that when transaction costs and the notoriously high hedge fund fees are figured in, the net return on merger arbitrage strategies falls, resulting in a Sharpe ratio of only 0.3%.
The reason for this, the group concludes is “the majority of managers have achieved their returns by “drifting” and taking on significant equity market exposure. They did not follow the pure market-neutral merger arbitrage strategy.”
“Merger arbitrage managers appear to have been punished for drifting as the equity market precipitously declined,’ CMRA’s report states.
According to a report from Reuters, industry members back up this view. Parker Global Strategies, a manager of managers for hedge funds, notes that a number of merger arbitrage funds in the market were currently known to be carrying long equity positions.
CMRA’s research revealed a high correlation between pure merger arbitrage strategies and the S&P 500 between December 1996 and March 2000 but low correlation beginning from October 2000.
And, if one examines the markets following the terrorist attacks last year, it becomes evident that managers were planning the equity market more than they were playing the “pure” strategy, CMRA notes. In September 2001,
- the pure merger arbitrage strategy delivered a positive return of 2.5%
- while the Hedge Fund Research merger arbitrage index lost 3%, and
- the S&P was down by 8.2%