Take Advantage of Merger Arb the Easy Way

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On December 13, 2012, ProShares launched the ProShares Merger ETF (NYSEMKT: MRGR) to much fanfare. MRGR is the first ETF designed specifically to capture the S&P 500's Merger Arbitrage Index's performance while reducing the risk associated with investing in its individual components. The ETF's stated goal is to mirror the performance of this index before accounting for overhead expenses and fees. It will deal primarily in U.S.-traded companies based in developed-market countries.

The Fund Makeup

True to its intention to mirror the makeup and performance of the Merger Arbitrage Index, MRGR will hold long positions in up to 40 known takeover targets. When a deal is announced and subsequently picked up by the S&P index, MRGR will initiate a standard long position in the deal's target company. At the outset, each position will be weighted at 3 percent of the fund's total capitalization.

In deals that involve the issuance of the acquiring company's stock to the taken-over company's shareholders, ProShares may choose to initiate a short position in the stock of the acquiring company. These positions are likely to comprise a smaller proportion of MRGR's total portfolio. None of MRGR's short positions are likely to exceed 3 percent of the fund's total capitalization.

Since it began trading on December 13 at an offering price of $40, MRGR's value has ranged from $38.98 to $40.15. It trades at an average daily volume of about 20,000 shares.

Other Merger Arb Funds

Although MRGR is the first ETF designed solely for the purpose of increasing investors' exposure to mergers and arbitrage activities while simultaneously reducing the associated risk, it is not the first ETF to explore this lucrative space. For instance, IQ Global Resources (NYSEMKT: MNA) offers a merger-arbitrage ETF that focuses heavily on global deals.

However, IQ's ETF hedges its long positions in known takeover targets with general short positions in global stock indexes. As such, it limits investors' exposure to specific deals while taking advantage of the positive spread between the stock prices of takeover targets and the performance of the broader market. Since its inception in November of 2009 at an initial offering price of $25 per share, MNA has touched a high of $26.67 and bottomed at $23.59. It currently trades near $24.75 and experiences moderate intra-day volatility.

Meanwhile, Credit Suisse offers an exchange-traded note known as the Merger Arbitrage Liquid Index (NYSEMKT: CSMA) that invests in North American and European takeover deals. Unlike ProShares's new ETF, CSMA often takes short positions in known takeover targets in order to capitalize on perceived weaknesses and uncertainties surrounding individual deals. Since its inception in October of 2010 at an offering price of $20 per share, its value has ranged between a high of $21 and a low of $19.25. It currently trades at about $19.70 per share and experiences relatively low intra-day volatility.

ProShares's new ETF seeks to employ a classic merger-arbitrage strategy that capitalizes on the spread between the stock prices of takeover targets and the companies that intend to acquire them. Since there may be more than 40 pending merger deals at any given time, MRGR will seek to take advantage of the most dynamic available deals. This may involve establishing positions in significantly-undervalued takeover targets and shorting acquiring companies that appear willing to offer large tranches of stock to their targets' shareholders.

It may also involve avoiding deals that appear to have little chance of passing regulatory muster or clearing shareholder-vote hurdles. Once a merger or arbitrage deal has been completed, MRGR will shed its positions in the companies involved. If new information or events indicate that a deal is likely to fall through, MRGR may terminate its exposure to the deal before it is completed or cancelled. In addition, MRGR may terminate its exposure to equities that appear to have ceased appreciating or depreciating in response to a proposed deal.

With its combination of long and short positions in dynamic public companies, MRGR appears primed to be an important diversification tool. Historically, indexes and funds that track the performance of companies involved in merger and arbitrage deals have shown little correlation with broader-market indexes. MRGR may be especially useful for long investors who wish to mitigate risk exposure during market downturns. Although merger and arbitrage activity typically declines during recessions, MRGR's simple design may enable it to find value in individual deals and serve as an important hedge.

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