A shift in market dynamics calls for an alternative approach

Merger arbitrage is an alternative strategy whose objective is to take advantage of price discrepancies, observed after the announcement of an M&A (Merger & Acquisition) transaction on a listed company. It is especially suited for current market environment, as it presents an effective hedge in rising rate or inflationary environment. The strategy often displays a lower volatility compared to stocks with low correlation with traditional asset classes such as equities and bonds.

Merger arbitrage strategies typically involve building a diversified portfolio containing 50–60 holdings, each in a company involved in an M&A deal. The main risk associated with this portfolio is idiosyncratic – the market risk has been replaced by deal-failure risk. In other words, whereas stock-price movements generally track the broader market, movements in merger arbitrage spreads follow their own dynamic that’s driven by the steps in the corresponding deal. That means merger arbitrage strategies are only weakly correlated with equity markets – and with bond markets, too.

Merger arbitrage strategies are particularly well-suited to times of rising interest rates. Since the risk-free rate is one of the two components of a merger arbitrage spread, increases in this rate – i.e., the short-term interest rate – will automatically push up the expected return on a merger arbitrage strategy for the same level of risk.

This pattern appears to hold over extended periods of time. For instance, merger arbitrage spreads followed movements in interest rates between 1990 and 2008: they declined after the dot-com bubble burst in 2001 and rose during the 2004–2007 economic recovery. But the correlation was undone by the 2008 financial crisis and the ensuing era of 0% interest rates engineered by central banks.

At Carmignac, we’ve been expanding our alternative-investment capabilities for years and currently manage nearly €2 billion in this asset class. We formed a merger arbitrage team and appointed Fabienne Cretin-Fumeron and Stéphane Dieudonné as Fund managers. This move came in response to growing demand from investors seeking to diversify away from conventional asset classes and into those with reduced volatility and uncorrelated returns.

We launched two merger arbitrage Funds: Carmignac Portfolio Merger Arbitrage, which has a defensive profile and 2%–4% expected volatility; and Carmignac Portfolio Merger Arbitrage Plus, which is more dynamic and has 5%–7% expected volatility. These funds aim to seize M&A opportunities in the main developed countries. They’re both classified as Article 8 under the SFDR and are open to professional and retail investors in several European countries.