The objective strategy

BNP Paribas’ merger arbitrage fund is outperforming. Its objectivity is a key factor behind its success. Matthew Crabbe reports

Dealers are racing to launch products that synthetically reproduce hedge fundand proprietary trading desk strategies. But how do they make derivatives thatactually outperform the real thing? BNP Paribas says it has some of the answerswith a merger arbitrage index fund product that replicates an arbitrage fundstrategy by picking pairs of shares – that is, shares in companies thatare likely to be bought and shares in companies that are likely to be buyers.The scope of the index is global, although the market capitalisation of targetcompanies has to be at least E100 million, and no single company can contributemore than a 5% weighting to the index.

The companies are selected by an algorithm developed by Eric Trouslard of BNPParibas’ equity financing division. Aside from the fact that there are15 different inputs into that algorithm, BNP Paribas isn’t revealing anythingabout its stock selection and weightings. But the key thing, says the bank, isthe objectivity of the selection. Because it is unadulterated by market rumouror press reports, the index represents a contrarian strategy that stands to benefitfrom the narrowing and widening of spreads as other merger arbitrageurs rushin and out of position in herd-like fashion.

The algorithm ensures that the composition of the index is completely objective,BNP Paribas says. The number of company share pairs will rise and fall with thelevel of activity in the merger market, and a pair will be dropped from the indexin the event of the formal announcement of either a merger or the collapse ofmerger talks, or if the spread between the ‘target’ or ‘predator’ companyin the pairing reverses so that the target simply becomes too expensive.

Another advantage of the fund over a hedge fund alternative is that the investordoes not have to pay hedge fund-style performance fees or financing costs.

The performance of the fund indicates that the principle works. Back in 2000,at the height of the mergers and acquisitions (M&A) boom, the fund returned33%. Even when the market collapsed in 2001 and 2002, the fund still outperformedthe hedge fund merger arbs, returning 5% and 8.08% in those two years (see figure). “Ifthe M&A market is now set for a recovery, then we believe the fund will dowell too,” says Nicolas Blanchy, global head of equity finance at BNP Paribas.
Until recently, the merger arb fund has been traded on an over-the-counter basis.The COB, the French securities regulator, prohibits the sale of the hedge fundproducts to retail investors and the fund has only been available to qualifiedinvestors.

In February, however, BNP Paribas recruited the Euronext.liffe exchange to compilethe index for the fund. While a merger arb index product may not have widespreadappeal, Vincent Remay,

Euronext.liffe’s Paris-based director for equity products, says the exchangewould like to introduce listed products based on alternative investments forfund managers. A listed product would mean more liquidity in the merger arb indexwill make it easier to price derivatives, equity swaps and other leverage productsbased on it, says Blanchy.