M&A indexes getting second look after torrent of deals

With global M&A volume rising to its highest level since 2007, investors put more than twice as much money into event-driven strategies in the second quarter of 2014 as they did in the first quarter

Investors allocated more money this quarter to a hedge fund strategy that profits from mergers and acquisitions (M&A) activity than last quarter, even though most merger arbitrage strategies have underperformed the broader stock market so far this year.

The HFRX ED: Merger Arbitrage index, a benchmark for strategies that seek to profit from buying the shares of M&A targets and shorting the shares of buyers, had dropped 0.21% this year as of August 7. The S&P 500 index rose nearly 5% over the same period. As of August 1, global M&A volume stood at $2.27 trillion, up 43% year on year, according to data provider Dealogic.

"Merger arbitrage strategies have been a popular choice from our range recently," says Laurence Black, head of client strategy and solutions at Barclays in New York. "M&A volumes have been high, driven partly by the inversion trade and the fact that companies have a tremendous amount of cash on their balance sheets."

With global M&A volume rising to its highest level since 2007, investors put more than twice as much money into event-driven strategies in the second quarter of 2014 as they did in the first quarter, according to Hedge Fund Research, a data provider. Some asset managers say year-to-date performance has been affected by unusual events and is poised to rebound in the second half of the year.

Assets under management in Lutetia Capital's SGI Merger Arbitrage fund have grown by around a third since the beginning of the year, according to data from the asset manager. The fund follows a qualitative approach, meaning fund managers analyse each deal and decide what position it should have in the portfolio. As of August 7, the SGI Merger Arbitrage fund was up 0.81%.

An unusual feature of this year's M&A activity is the large number of transactions that are trading at unusually wide spreads, says Fabrice Seiman, Paris-based managing partner at Lutetia Capital. "Companies, especially ones in healthcare, have been striking tax inversion deals in the past year. But lately a chorus has risen against the deals, so the spreads on large transactions such as [AbbVie's proposed takeover of] Shire or [Medtronic's proposed takeover of] Covidien widened as a result."

Tax inversion transactions have become increasingly popular as US companies seek to reincorporate in lower-tax jurisdictions by combining with foreign companies. US President Barack Obama and Treasury Secretary Jacob Lew have called on Congress to pass legislation to curb these transactions, though the legislature has yet to act.

Twice this year, buyers were taken over before they could complete the purchase of their targets, events Seiman calls "very rare". In one instance, Hillshire Farms agreed in May to buy Pinnacle Foods before becoming the object of a bidding war itself, ultimately agreeing to sell itself to Tyson for $7.75 billion. It terminated its earlier deal to buy Pinnacle. Another instance involved Caracal Energy and TransGlobe Energy.

Lutetia's quantitative merger arbitrage strategy automatically shorts buyers and cannot exit a position until a deal is completed. The fund was stuck in wrong-way bets on these two deals and lost money.

There may be a more humdrum reason for the performance of these strategies so far this year: timing. M&A transactions tend to close towards the end of the year for tax reasons, which means that these funds' positions stand to pay out in the fourth quarter. "We believe that we have today a very good entry point for merger arbitrage strategies, with a combination of attractive spreads and increasing deal volume," says Seiman.