Try the 'Anti-Arbitrage' Merger Play

Those were the days, the days when investors flocked to all sorts of fancy hedge fund strategies and alternative investment opportunities that all seemed to pledge returns that were independent of, and higher than, plain old equity investing.

The choir of non-correlation sounded glorious, and investors and institutions heeded the call. Now the choir has been disbanded, and a few lonely singers hum a dirge for all these ideas. The hedge fund industry has found out that when it all really goes bad, everything is correlated. Fancy strategies that involved using huge leverage to exploit small anomalies worked until they didn't. When they stopped, the resulting loss took away years worth of gains.

Last night, James Altucher asked me where I thought the best arbitrage opportunities existed. My quick answer was nowhere. I just don't see the type of pricing inefficiencies that would create profitable arb opportunities. It occurs to me that if there are no outright arb situations available that can produce solid returns, there has to be value in what I call anti-arbitrage.

I looked at several of the standard hedge fund strategies to see if the blowups and selloffs had created exploitable trading and investment ideas. There is certain ecology to financial markets, and when an area burns down to the ground and capital flees that style, the resulting new growth can be quite profitable.

One area that has had a difficult time is merger arbitrage. Back in the 1970s and 1980s, risk arb was the place to be for outsized returns. Deals were announced, and there was routinely a spread of 30% or more available to the arbs. As more firms entered the business, spreads declined. To maintain the high returns, risk arbs added leverage.

When deal financing dried up starting last year and mergers began to be terminated because of lack of financing and falling stock prices, the other side of the leverage sword came into play. Risk arb funds had to dump their positions quickly, pushing these stocks to prices below where they were before the deal.

---

At the time of publication, Melvin had no positions in stocks mentioned, although positions may change at any time.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider EPIX, BRNC, ALY and CHIC to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.