As the economy continues to ebb and flow, many investors are having trouble gauging the stock markets. With each bit of news, either good or bad, it seems that the broad stock market reacts in wild swings. This severe increase in volatility requires new levels of sophistication in portfolio construction. Numerous investors are looking towards market neutral strategies or portfolios that can make money in any environment as a way to ride out the storm. One such strategy is riding high on a recent wave of corporate deal making - this might be just what investors are looking for.

IN PICTURES: Eight Ways To Survive A Market Downturn

$1.8 Trillion
With interest rates still at paltry levels, corporations with excess cash are feeling the pain just as much as retirees. With nearly $1.8 trillion sitting in the S&P 500's coffers earning next to nothing, it is no surprise that merger mania has returned to the stock market. Merger activity has surged nearly 79%, year over year. Bloomberg reports that nearly $1.6 trillion in takeover deals have been announced so far in 2010, with $562 billion in the third quarter alone. This has been the fastest pace since the global slowdown. Companies in the S&P 500 are trading at just a forward P/E of 12.5, well below the 16.5 historical 20 year average.

With stocks so cheap and so much cash lining the pockets of business, mergers and acquisition are an ideal way to deploy that cash. For example, Intel Corporation (Nasdaq:INTC) with nearly $15 billion on its books, recently bought the wireless unit of chipmaker Infineon (NYSE:IFNNY) for $1.4 billion and made a $4.7 billion offer for McAfee (NYSE:MFE).

It is within this deal making that investors can profit. At its simplest, arbitrage involves profiting from the difference between the deal offer price and the current stock price. It's in these $1 to $2 differences, which arbitragers hope to profit from. The risk in the trade involves if the deal falls through or at happens at a much lower amount. Many hedge funds add short positions in the acquirer's stocks or futures contracts to circumvent this risk. However, merger arbitrage works best over several different deals and opportunities, requiring heavy capital constraints making it pretty inaccessible for most retail investors.

Staying Market Neutral
As investors crave more advanced tools for portfolio construction, Wall Street complies. The exchange-traded fund boom has given investors some choice within the merger arbitrage space.

The Credit Suisse Merger Arbitrage Liquid Index ETN (Nasdaq:CSMA) is the newest entrant to the space. The underlying index is rebalanced every five days, rather than monthly or quarterly, allowing for the fund to capture these event driven gains. Expenses run at a relatively cheap 0.55% and back testing of the underlying index results in a 6.54% annual return over the last 5 years. The IQ ARB Merger Arbitrage ETF (NYSE:MNA) follows a somewhat similar strategy.

During the very active M&A and private equity cycle of 2003-2007, the S&P 500 Value index outperformed its growth twin by nearly 30 percentage points. Another way to play this boom in mergers may simply be to bet on value stocks. The iShares S&P 500 Value Index (NYSE:IVE) and iShares S&P Mid Cap 400 Value Index (NYSE:IJJ) might be the real winners in all of this merger growth. In addition, just about 33% of recent merger activity has been in the energy sector. As larger energy companies look for new shale plays and reserves, both the PowerShares S&P Small Cap Energy (Nasdaq:XLES) and Jefferies TR/J CRB Wildcatters E&P (Nasdaq:WCAT) could see their prices rise.

Bottom Line
With cheap stock valuations and large cash hordes, merger mania has returned to the markets. As more investors look for alternatives to stay market neutral and protect their portfolios, opportunities exist to profit from this growth in acquisition activity. By using the previous merger-arbitrage funds or value ETFs, investors can add the strategy to their portfolios. (While acquisitions can be hostile, these varied mergers are always friendly. To learn more, see The Wonderful World Of Mergers.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI Emerging Mkts

    Learn more about the PowerShares FTSE RAFI Emerging Markets ETF, a fundamentally weighted fund that tracks emerging market equities.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Cali AMT-Free Muni Bond

    Learn more about the iShares California AMT-Free Municipal Bond exchange-traded fund, a popular tax-advantaged ETF that dominates its category.
  3. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Emerging Markets Dividend

    Learn more about the SDPR S&P Emerging Markets Dividend Fund, a yield-focused exchange-traded fund tracking global emerging economies.
  4. Mutual Funds & ETFs

    ETF Analysis: First Trust Dow Jones Global Sel Div

    Find out about the First Trust Dow Jones Global Select Dividend Index Fund, and learn detailed information about characteristics and suitability of the fund.
  5. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Short S&P500

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  8. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Investment Grd Fl Rt

    Learn more about the SPDR Barclays Investment Grade Floating Rate Fund, which tracks an index of highly rated floating debt securities.
  9. Mutual Funds & ETFs

    ETF Analysis: ALPS Medical Breakthroughs

    Learn more about a unique and innovative exchange-traded fund (ETF) in the biotechnology industry: the ALPS Medical Breakthroughs Fund.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Healthcare

    Learn about the iShares U.S. Healthcare exchange-traded fund, which invests in a wide range of health care providers, hospitals and home care facilities.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  5. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  6. Lion economies

    A nickname given to Africa's growing economies.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!