Carl Icahn, Henry Kravitz, Sumner Redstone and a host of other financial pros make their money by using complex strategies that reduce risk while maximizing potential gains. However, there is one strategy that towers above all others when it comes to minting members of the billionaires' club.
The best part is that today, every investor can participate in this strategy -- without the need for hundreds of millions of dollars, inside information, or a seat at the corporate roundtable. This strategy, which was very popular in the 1980s, has enjoyed a dramatic resurgence during the bull market of the past several years, thanks to huge corporate cash reserves, low interest rates and volatility, and the increasing importance of cutting costs and boosting growth to keep shareholders happy.
That's the funny thing about bull markets: No matter how high the market climbs or the returns earned, it's never enough to gratify investors. That's why this strategy has become so popular that more than $650 billion of transactions have taken place this year alone, with the biggest deals creating headlines around the world.
The strategy I'm talking about is mergers and acquisitions, or M&A. You may have heard of the Warren Buffett-led $23 billion takeover of Pittsburgh-based ketchup maker Heinz and the merger of airlines U.S. Airways (NYSE: LCC) and AMR Corp. Those deals and many others have taken place this year alone. Pending deals include private equity firm Cerberus Capital Management looking to buy BlackBerry (Nasdaq: BBRY) and clothier Men's Wearhouse (NYSE: MW) being pursued by rival Jos. A. Bank (Nasdaq: JOSB).
The way through which big investors -- even those not directly involved with individual M&A deals -- make fortunes is with a strategy known as merger arbitrage. In fact, you don't even have to be a big investor to use merger arbitrage, which is simply the selling of the acquiring company's shares and the concurrent buying of the acquired company's stock. The way it works is the target company's shares often sell at a discount to the value of the company doing the acquisition due to the risk of the merger not occurring or being delayed. It is the difference in price -- which becomes profit for the investor.
The bad news about this strategy is that while it's possible for any investor to execute this merger arbitrage, it's exceedingly difficult to time everything correctly without institutional-level information. The good news is that there are exchange-traded funds (ETFs) that employ the merger arbitrage strategy. Here are a couple of my favorites.
Credit Suisse Merger Arbitrage Index Leveraged ETN (NYSE: CSMB)
CSMB is not technically an exchange-traded fund. It is structured as an exchange-traded note, which is similar to an ETF but different in a few ways. The ETN was created in 2011 and is up 12% this year. As its name suggests, it's leveraged two times and tracks a basket of securities with long and short positions that have announced mergers or acquisitions.
IQ Merger Arbitrage ETF (NYSE: MNA)
MNA tracks the performance of the IQ Merger Arbitrage Index, which purchases shares of companies that have publicly announced they are being taken over. However, rather than shorting the acquiring companies, the index has short exposure to global equities to create a partial hedge. The fund was founded in 2009 and is up 6% this year.
Risks to Consider: Merger arbitrage ETFs and ETNs trade at extremely low volumes, which may make selling your holdings difficult at times. In addition, these ETFs can and do lose money when the strategy is miscalculated. It's important to note that the few mutual funds that have existed in this field over the past decade have failed to beat the overall market returns.
Action to Take --> Merger arbitrage ETFs and ETNs are ideal for those investors who are seeking to diversify into uncorrelated equity investments. Having a small stake in this strategy can help smooth your equity curve while at the same time adding to your bottom line.