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
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
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
Another position shows the market risk that the ETF sometimes takes. Vulcan Materials
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.
Fool contributor Dan Caplinger rarely turns down free money -- when it's really free. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. Motley Fool newsletter services have recommended buying shares of and creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has no risk at all.