Merger Space Gains New ETF, New Strategy

NEW YORK ( TheStreet) -- If the current bull market and economic expansion are close to their respective ends then investors will likely gravitate to absolute return and market-neutral strategies which might be why ProShares this week launched the ProShares Merger ETF ( MRGR).

Generically speaking, this is a merger arbitrage fund, a strategy that has been available for many years in retail products. The Merger Fund ( MERFX) and the Arbitrage Fund ( ARBFX) once dominated the space. Then, three years ago, the first ETF hit the market with the IndexIQ ARB Merger Arbitrage ETF ( MNA).

The general idea of the strategy is to buy the company being acquired and sell short the acquirer after the deal has been announced. The strategy assumes that the company being acquired won't quite trade up to the acquisition price until the deal closes because there is always a chance that an announced deal will not close.

Ideally the long/short exposure will deliver an absolute return not correlated to a broad market index like the S&P 500, which would be useful the next time the market goes down a lot.

Both MERFX and ARBFX apply this strategy in a straightforward way, going long the company being taken over and short the acquirer. The underlying strategy for MNA, on the other hand, is to go long the company being taken over and sell short the broad market. IndexIQ's research tells them that this way of setting up the arbitrage will work.

The specific methodology underlying the new MRGR is unique vs. the other funds. MRGR will go long the target company with a 3% weighting and will sell short the acquirer to the extent the terms of the deal call for shareholders to receive stock.

Any cash deals or cash components of combination deals will not be sold short. When there are not enough deals to populate the fund it will own Treasury bills until more investable deals are announced.

As mentioned, there are three funds already in the space and they have reasonably long track records. MNA is the newest of the existing three funds and since MNA's inception the results of the three funds don't look anything alike.

Keep in mind the funds are executing variations on the same strategy and there are many overlapping holdings across the funds yet the results are different. It should be noted that the new MRGR also has many holdings in common with the other three funds.

MNA has lagged meaningfully behind MERFX since its inception and lagged slightly behind ARBFX. It obviously remains to be seen whether MRGR will lag, lead or be right in the middle of the pack.

A few years ago I personally purchased MERFX. The idea at the time in going with that fund instead of MNA is that MERFX is actively managed and the manager has more freedom to make qualitative decisions vs. a rules-based index that does not have the same freedoms; both ETFs are rules-based.

The stock market cycle may be near an end, especially if "fiscal cliff" fears turn out to be warranted, and this will draw more attention to defensive strategies like merger arbitrage but not all defensive strategies will lend themselves to a rules based index.

At the time of publication, the author had a personal holding in MERFX.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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