Merger arbitrage strategies – A powerful tool to manage market volatility

by: , Chief Investment Officer and Managing Director | IndexIQ; Dan Petersen, CAIA®, Director, Product Management, IndexIQ; Mark Lacuesta, FRM, CAIA, CIPM, Director of Index Strategies, IndexIQ

In times of market stress, investors often consider rash decisions of moving between risk-on equity exposures to risk-off vehicles, often when it is already too late. October has been a difficult time in the market, with the S&P 500 experiencing a six-day losing streak, its longest in two years, trading near its July 2018 level. Coming off one of the least volatile years in history, this type of market movement can be disturbing, but should be viewed in the longer-term context.

Breaking down some of the events that led up to the recent pullback, Federal Reserve messaging removed the word “accommodative” from its most recent post-meeting statement, and several Fed officials have suggested an intent to continue gradually raising rates. Higher rates generally increase the cost of capital for companies and lead to a higher discount rate for future earnings, making them less valuable now. The continuation of tariff talks may explain why Technology was hit harder than other sectors, over fears that their costs from overseas manufacturers could increase. Increases in Energy inventories leading the price of oil lower could have explained some of the energy sector losses.

When market sell-offs occur, investors immediately focus on the volatility of their portfolios as a targeted area for improvement and with the proliferation of Smart Beta strategies, investors have several solutions to address their concerns. However, while managing volatility is an important objective, investors must also consider correlation within their portfolio construction. Herein lies the benefits of Liquid Alternatives: daily access to strategies that are less correlated to traditional asset classes, potentially providing a differentiated source of return.1

One direct approach to tackling the high volatility of the S&P 500 major market index is the low volatility factor used by the S&P Low Volatility Index. In this index, the 100 names of the S&P 500 that exhibit the lowest trailing 12-month standard deviation (measure of volatility) are used instead of the full 500 names. If we look over the long-term2, the annualized volatility of the S&P 500 and S&P Low Volatility Index are 14.7% and 11.37%, respectively. The problem with using standard deviation in isolation is that there are plenty of stocks that have risen in a smooth fashion, exhibiting low volatility on the way up but ultimately having a relatively large potential to correct. The FANG stocks (Facebook, Amazon, Netflix, and Google), are a great example, being partly found in the S&P Low Volatility Index as it stands today. If we consider a Liquid Alternative strategy such as the IQ Merger Arbitrage Index, its volatility is at 4.57% (see chart below).

Annualized historical volatility

Source: Bloomberg, IndexIQ. Daily Annualized Volatility: 11/16/10 to 10/11/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Looking at long-run volatility versus the one-year rolling volatility, we can see how Low Volatility by itself does not address the full risk picture. Volatility does exhibit a mean-reverting tendency and this chart would indicate that rising volatility is in store for the S&P 500. Comparatively, the IQ Merger Arbitrage Index exhibits lower volatility on an absolute basis while also trending near its longer-term volatility level.

Increasing volatility, however, should not cause investors to completely run for the hills but rather give them pause to prepare their portfolios to weather the risk. Liquid Alternative strategies may have some of the same asset class exposures investors hold in their portfolios, but their construction leads to lower correlation strategies to equities and fixed income. Looking at the five-year correlation as of 9/30/2018, incorporating additional asset classes into your portfolio that exhibit low correlation to each other are necessary to offer additional diversification benefits to help control risk. For example, the IQ Merger Arbitrage Index exhibits 0.32 correlation to the S&P Index and -0.12 correlation to the Bloomberg Aggregate Bond Index.3

IQ Merger Arb Index MSCI EAFE Index Bloomberg Aggregate Bond Index S&P 500 Index FTSE NAREIT Index Bloomberg Commodity Spot Index
IQ Merger Arb Index 1.00
MSCI EAFE Index 0.26 1.00
Bloomberg Aggregate Bond Index -0.12 -0.10 1.00
S&P 500 Index 0.32 0.46 -0.28 1.00
FTSE NAREIT Index 0.24 0.59 0.14 0.57 1.00
Bloomberg Commodity Spot Index 0.15 0.32 -0.11 0.26 0.20 1.00

Source: Morningstar; Time period: 5 years monthly ending 9/30/2018. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Incorporating a liquid alternative strategy, such as the IQ Merger Arbitrage Index, has shown an ability to avoid the tail-risk (i.e. large negative losses) associated with increased market volatility. As seen in the chart below, on October 10 and 11, when the S&P 500 was down -3.29% and -2.06%, the IQ Merger Arbitrage Index returned .10% and .06%.4

Market stress

Source: Morningstar, as of 10/11/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Value-at-Risk (VaR) is an often-used measure for risk which provides a probability level of minimum loss over a set period (day, week, month, etc.). For example, the 5% one-day VaR of the S&P 500 going into October 10 was -1.24%. Translation: there was a 5% probability that the S&P 500 could decline by more than -1.24% over the current day which it did at -3.29%. The following day, the 1-day VaR for the S&P increased to -1.30% which it exceeded again at -2.06%. While seeking lower volatility strategies may seem attractive, correlation can’t be ignored. Over the same two-day period, the S&P 500 Low Volatility Index 5% 1-day VaR was -1.02% and -1.04% respectively which it exceeded both days.

Comparatively, the IQ Merger Arbitrage Index one-day VaR limits remained at its -0.42% level over the market sell-off, which it did not exceed. More importantly, looking historically, the IQ Merger Arbitrage Index has breached its VaR limit less than 5% of the time looking over a contemporaneous period with the S&P 500. This lower than 5% exceedance occurrence illustrates the strategy’s ability to control tail-risk by delivering on the expectation of avoiding extreme losses.

Liquid alternative strategies with low correlation to broad asset classes may serve as a ballast to a portfolio over the long haul, exhibiting attractive risk-control characteristics to offer investors powerful tools to help their portfolios weather short set-backs to help achieve their long-term goals.

1. Source: Morningstar; Time period: 5 years monthly ending 9/30/18.

2. Annualized volatility of 14.7% and 11.37% calculated from 11/16/09 to 10/11/18. Annualized volatility for IQ Merger Arb Index of 4.57% over the same period. Data from Bloomberg and IndexIQ.

3. 0.32 and -0.12 correlation calculated from Morningstar using Monthly Returns, 5-years ending 9/30/2018.

4. IndexIQ Returns, as of 10/11.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

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The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.

The Bloomberg Commodity Spot Index measures the price movements of commodities included in the Bloomberg CI and select sub indexes.

FANG represents the most popular and best performing tech stocks in the market that have generated spectacular returns for their investors. The four stocks — Facebook, Amazon, Netflix and Alphabet — all trade on the NASDAQ, which measures the performance of more than 3,000 tech and growth stocks that are considered a reflection of the economy and capital market.

The FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.

HFRI ED Merger Arbitrage Index tracks the investment process primarily focused on opportunities in the equity and equity related instruments of companies which are currently engaged in a corporate transaction.

The IQ Merger Arbitrage Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ.

The IQ Merger Arbitrage Index seeks to achieve capital appreciation by investing in global companies for which there has been a public announcement of a takeover by an acquirer.

Liquid alternatives (liquid alts) are alternative investment strategies that are available through alternative investment vehicles such as mutual funds, ETFs, and closed-end funds that provide daily liquidity.

The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.

The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.

The S&P 500 Low Volatility Index measures the performance of the 100 least volatile stocks in the S&P 500® based on their historical volatility. The index is designed to serve as a benchmark for low volatility investing in the US stock market.

Smart beta investing combines the benefits of passive investing and the advantages of active investing strategies. The goal of smart beta is to obtain alpha, lower risk or increase diversification at a cost lower than traditional active management and marginally higher than straight index investing.

Standard deviation – A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.

Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Tail risks include events that have a small probability of occurring, and occur at both ends of a normal distribution curve.

Value at risk is a statistic that measures and quantifies the level of financial risk within a firm, portfolio or position over a specific time frame. It is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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Dan Petersen, CAIA®

Director, Product Management, IndexIQ

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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Mark Lacuesta, FRM, CAIA, CIPM

Director of Index Strategies, IndexIQ

Mark is Director of Index Strategies at IndexIQ where he is responsible for overseeing IndexIQ’s proprietary and third-party indexes underlying the firm’s ETF offerings. In this role, Mark is involved with research, product development, trading, sales, and marketing

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