Exchange-traded fund accentuates merger arbitrage highs, and lows

NEW YORK Tue Aug 19, 2014 8:06am EDT

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NEW YORK (Reuters) - For merger arbitrage funds playing this year's hot deal-making market, one exchange-traded fund has pulled ahead - on the upside and the downside.

With a 3.5 percent year-to-date return, the IndexIQ Merger Arbitrage ETF (MNA.P), or MNA, is handily beating its actively managed mutual fund peers. But it lost ground twice as fast as those peers when two high-profile deals collapsed recently.

The fund's volatility may reflect the way it is managed. As a passive index fund, it follows a rules-based approach, adding shares when a new deal is announced and selling them when a deal closes, and changing its portfolio just once a month. In contrast, the actively managed, merger-focused funds rely on human judgment and tend to jump in and out of stocks more frequently.

The impact of the way MNA is managed can be seen in recent events. When Twenty-First Century Fox (FOXA.O) suddenly pulled its bid for Time Warner Inc (TWX.N) earlier this month, MNA got stuck holding overpriced Time Warner shares and dropped 2.2 percent in two days, while the six merger arbitrage mutual funds tracked by Reuters fell between 0.29 percent and 0.79 percent over the same period.

MNA also took a hit on its holding of shares of T-Mobile U.S. Inc (TMUS.N) after a bid for that company imploded earlier this month

Year-to-date, though, "MNA is really running away from the pack with respect to performance," said Paul Britt, a senior ETF analyst with research and analytics firm ETF.com. MNA's 3.5 percent return is far ahead of the returns booked by the six actively managed merger arbitrage mutual funds, which range from a 2 percent loss to a 2.37 percent gain.

Merger-arbitrage funds aim to eke out steady returns by playing the spreads between a company's market price and the price at which it may be acquired. Because they focus on deals that have been announced, they tend to have much smaller returns than hedge funds that may make riskier bets. Institutional investors and financial advisers use merger arbs funds to diversify and add returns to their portfolios.

They have been attracting assets this year, as global deal volumes have risen to their highest level in seven years, to $1.75 trillion in late June, up 75 percent from the year-ago period, according to Thomson Reuters data. Assets in MNA have doubled since the end of December to $57.23 million and are on track to triple, said Kevin DiSano, an executive vice president at IndexIQ.

SLOWER RESPONSE TIMES

Time Warner is still the third largest stock held by MNA, with a 6.56 percent weight, as of Friday, even following Twenty-First Century Fox's withdrawal of its offer for the company. Time Warner Inc shares have dropped about 8.3 percent since the start of the month.

That's been hard on the fund, concedes DiSano, though he said the automated nature of the portfolio can serve it well over time. People might sell too low when a deal collapses, he says.

"By keeping it in the portfolio until the next rebalance, you're at least giving it an opportunity to rebound a little bit," he said.

(Reporting by Ashley Lau in New York; Editing by Linda Stern and Leslie Adler)

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