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After the financial crisis that sent stock markets to their lowest levels in over a decade, gun-shy investors looked for different ways to try to make money from their investments. Many little-known types of investments, such as mortgage REITs, master limited partnerships, and managed payout funds, took advantage of the hunger for income and delivered some solid returns.
Another strategy, however, has fallen short of the potential that many investors saw for it. The IQ Merger Arbitrage ETF sought to profit from companies that were targets of takeover attempts. So far, though, the fund has had a tough time avoiding losses, despite an overall stock market that has posted significant gains since the fund started trading.
The appeal of mergers
Merger arbitrage in its purest form is a way to bet on an announced acquisition actually going through. For instance, United Technologies (NYSE: UTX ) has had an offer on the table to buy Goodrich for $127.50 per share in cash. But when you look at Goodrich shares, they traded recently for about $125.41, leaving a difference of more than $2 per share. With the deal expected to close sometime next month, a return of about 1.6% in four to eight weeks beats the pants off a savings account earning 0.05% per year.
The risk with any merger, however, is that something will happen to kill the deal. Whether it's a regulatory obstacle -- as happened with AT&T's attempt to buy out T-Mobile last year -- a failure to get shareholder approval, or an obstinate management team, anything that prevents the deal from going through can send shares of the target company plunging.
Another source of possible returns can come from bidding wars. For instance, a few years ago, Green Mountain Coffee Roasters (Nasdaq: GMCR ) fought against Peet's Coffee & Tea to acquire Diedrich Coffee. Peet's started the bidding at $26, but the company eventually went for $35 per share. Investors who got in on Diedrich early on earned amazing profits.
What went wrong?
But since November 2009, when the IQ Merger Arbitrage ETF came out, it hasn't had much luck producing attractive returns. Shares trade below the $25.25 closing price of their first day of trading, although the ETF's dividend distributions have boosted performance enough to give it an overall positive total return. But the fund has posted losses over the past year.
A look at its current holdings provides some examples of problems it has faced recently. With a sizable position in Avon Products (NYSE: AVP ) , the ETF has had to suffer with a management team that turned down multiple offers from Coty at prices well above current 52-week lows. Similarly, Human Genome Sciences (Nasdaq: HGSI ) has been fighting hard against a hostile takeover bid from GlaxoSmithKline and recently had a court uphold its takeover-defense strategy.
Another position shows the market risk that the ETF sometimes takes. Vulcan Materials (NYSE: VMC ) is another holding that has seen losses lately after fending off a hostile bid. Martin Marietta Materials offered half a share of its stock for every share of Vulcan, but a court decision found that the bid violated a confidentiality agreement between the two companies and ordered that the bid be disallowed for a four-month period.
That market risk is inconsistent with a pure arbitrage strategy, which instead would have sold shares of Martin Marietta short to hedge against the possibility that both stocks would drop. But the ETF did not, and thus has seen greater losses as the entire materials sector has faced a big downdraft recently.
Keeping it simple
Perhaps the biggest barrier to merger arbitrage investing right now is the low interest rate environment. With Treasuries paying next to nothing, spreads on arbitrage opportunities are relatively low -- providing less insulation against things going wrong. Add to that a 0.75% expense ratio for the ETF, and it's exceptionally hard for it to provide good returns -- especially when companies seem so averse to takeovers. It'll take better luck and a healthier market environment for merger arbitrage to start producing better returns.
Sometimes, the simpler approach to investing is best. Rather than trying to pick up pennies on merger targets, holding great stocks for the long run can provide much more attractive returns. It's easy to find three great prospects for your portfolio in The Motley Fool's special report on long-term investing. But don't wait -- click here and start reading your free copy right now.