Corey Hoffstein: Stacking Merger Arbitrage with the RSBA ETF

Corey Hoffstein: When a company, when there's an announcement that one company is going to buy another, if this is a public company that's trading, the company that's getting acquired, typically its share price is going to jump up towards the announced price, but it typically doesn't go all the way. There's usually a spread left, and that spread is going to represent two things.

One, it's going to represent the time value of money. The deals typically aren't closing imminently. They're typically closing, say an expected deal time might be six to 12 months, and so the market's going to build in some sort of time value of money for that deal to close. The other thing the market is going to price in is the expected expectation of any deal break.

We have very strong laws about mergers and acquisitions in the U.S., but there's still a probability that a deal might fall apart for capital reasons, or a deal might fall apart because of regulatory reasons. And so that represents deal break risk, and that's going to be baked into the premium as well.

And so you can almost think of, you know, how far the deal jumps, how far the stock price jumps from where it was trading to, announced deal prices, sort of a pseudo probability of how much the market thinks the deal is likely to get done with some time value money baked in there. And so what Merger Arbitrage does is it says, after the deal has been announced, we are going to buy into that acquire company.

If it's an all cash deal. If it's a cash plus stock deal, we're going to buy into that company and short the stock of the acquirer. If it's a public company, and then we're going to try to capture that remaining spread over time. Uh, it's less an arbitrage in the sense of a true arbitrage. I like to think of it as a risk premium, right?

A lot of those investors who are along for the ride got that initial jump. There's a little bit of juice left to squeeze in that spread, and so when you're stepping at that price that you are taking on the risk. The deal could fall apart. You're taking on the risk that the deal might take longer than the market's expecting.

And so by taking on those risks, you should earn a risk premium. And so a well diversified M&A portfolio in the public markets once these deals are announced, um, should look very much like sort of a mix between a. Uh, duration, you know, a low duration portfolio, you're getting paid, compensated for that time, value, money, premium, and a little bit of something that looks, uh, a little bit like credit risk.

It's not perfectly credit risk, but it's sort of credit risk adjacent and it's a different unique risk premium that you can earn.

There's two ways I'd want to answer this. One is, is. An evergreen answer, right? When we're building portfolios, I think it's always prudent to be looking to diversify across as many unique risk premia as possible. When we look at the returns of a merger ARB strategy, it's lowly correlated to bonds. It's got about a correlation of 0.5 to equities, a correlation of about 0.5 to the credit risk premium.

And so as we're looking to just further diversify our portfolios structurally, I think it's a, it's a great. Evergreen allocation at this point in time. We're in an environment where credit spreads are very, very thin, and so four more conservative investors who have a lot of investment grade, corporate bond exposure, or even high yield bond exposure.

The question you have to ask is, are we being fairly compensated for the risk we're taking? Particularly if there is a potential hard landing coming around the corner from an economic perspective. I'm not going to prognosticate on that. Right? But when you have credit spreads this thin, the margin for error is quite, quite low.

And so one of the things we're talking a lot about is saying, well, what if you took the merger risk premium and put it on top of treasuries? Right? What you end up with is something that over the long run looks a lot like a corporate bond return profile, but the excess return that you're earning above the treasuries isn't coming from credit risk.

It's coming from deal break risk. And again, there's some low correlation there. There is some similarities in certain markets, but it is its own unique risk premium. And so we think it makes a great diversifier to corporate bonds in an environment like we're in today.

The expectation is typically there is a bit of cyclicality to Merger Arbitrage, right? People typically think, oh, there's a big recession, right? That's bad for M&A, and that is true to a certain extent, and that's where you do tend to see a little bit of correlation between Merger Arbitrage and credit. And equities M&A deals might dry up. It might take longer for people to get the financing, but we have very, very strong M&A laws in this country. The example I always give is Elon Musk buying Twitter, now X, right? He made a proposal in a somewhat joking manner, and then Delaware law forced him to buy Twitter, right?

So it's very hard to get out of these deals once they're announced. And so when you look at a diversified Merger Arbitrage portfolio, you're talking about a diversified set of idiosyncratic risks, versus when you look at credit, you tend to be looking at something that is far more cyclical and tends to have a lot more correlation to equity markets, because it's sort of a pseudo proxy for what's happening in the economy. And so it's not to say there isn't some sort of economic similarity to them. Again, that correlation is about a 0.5, but it's not perfect, and you tend to find that M&A strategies, Merger Arbitrage strategies have far less downside correlation to equities than credit does.

I think what you find with a traditional Merger Arb strategy, if you're just buying an off the shelf merger strategy, this is typically like a short duration bond fund.

And so that's where we would recommend people fund this allocation from it. They should sell some of their core investment grade corporate bonds, buy some of a portfolio like this, the Bonds plus Merger Arbitrage strategy. And in doing so, we think over the long run you get a very similar return profile.

I actually think Merger Arbitrage has historically been more attractive than the credit risk premium. But let's say it's, it's the same. The benefit there really is then the diversification, right, that you're just adding yet another risk premium to your portfolio, and helping spread your bets into unique places that you should get paid for allocating your money.

The framework here is hopefully very simple. For every dollar you invest in RSBA, our goal is to give you a dollar of core U.S. Treasury exposure, plus a dollar of Merger Arbitrage exposure. And this is the core concept behind Return Stacking, right? Traditional forms of diversification always say, was addition by subtraction. To add diversifiers to your portfolio, you had to subtract typically either core stocks or bonds or a mixture thereof. What return stacking aims do, and what we seek to do in the Return Stacked® suite is provide investors with that core beta and stack the alternative on top. So, as an example with RSBA, when you give us a dollar, we're going to give you a dollar of core US treasuries and then add that Merger Arbitrage strategy on top.

And so what that means is that if an investor sells their US treasuries and buys RSBA, they're getting that U.S. Treasury exposure back. The Merger Arb strategy is then layered on top, and that can be one approach to introducing this strategy. It's just to add yet another return stream, potentially enhancing the returns of the portfolio.

Or as we mentioned earlier, this is an interesting way to rethink how we're allocating to bonds entirely, right?

And so one of the really compelling opportunities we think, is to sell some of those corporate bonds to buy RSBA as a diversifier, right, getting a very similar long-term risk and return profile. Both credit and Merger Arb have historically returned between 200 to 300 basis points in excess returns over time, but have done so in very different ways.

Again, those risk premium have had a correlation to each other of only about 0.5 over time, and so we think that's a very compelling use of this return stacking framework to create, you know, again, a similar total return profile to what investors are used to, but using a novel risk premium that they probably don't and aren't accessing in their portfolio today.

When we think about beating the market, right, there's very few ways in which you can actually do that. You can pick securities better. Maybe you go into your stock allocation and pick stocks better to beat the market, or you do that in your bond allocation.

You can do tactical asset allocation, right, switch between stocks and bonds. But these approaches typically rely on one person winning and one person losing, right? They're more typically relying on behavioral phenomena. What's really interesting about Merger Arbitrage as a strategy is that we really think it's a risk premium, that by investing in Merger Arbitrage, you should expect to earn a return because you are bearing a risk, the same way you should expect to earn a return for bearing credit risk.

The same way you should expect to earn a return for just bearing bonds, the bond risk premium, or expect to earn a return. Why do equities go up the equity risk premium? And so for us, from a conviction perspective, right, what do we think will continue to work over the long run? We have very high conviction in risk premium, and we think Merger Arbitrage is a very strong risk premium, from both an empirical and theoretical basis.

And so when we look at continuing to diversify our portfolio or adding novel return streams on top of our portfolio, to me it makes a lot more sense to try to focus on those areas that we really think are risk premium, before we start to explore these other approaches to beat the market.

When you look at Merger Arbitrage as a category, you don't tend to see a huge amount of allocation to Merger Arbitrage among financial advisors. So again, it goes back to this problem of clients aren't starting with a blank canvas. They're typically, mentally, behaviorally anchored to what's happening with stocks and bonds.

And so. If you can't keep up with stocks and bonds, which Merger Arbitrage has not kept up with stocks and bonds, they typically just want to get rid of it because it tends to be higher costs, less tax efficient, more opaque. It's just not something they understand.

And so to me, what's so compelling about our approach is you're getting the core bonds back. You're stacking the Merger Arb, this novel risk premium, on top. I think it's a very compelling risk premium over the long run and what you're creating through that combination is something that's going to look a lot like investment grade corporate bonds to a client, and that's something that I think clients can hold onto for the long run, harvesting those diversification benefits.

When we're looking to build a portfolio, we should be looking for that breadth, particularly that breadth of risk premium, right? People allocate to stocks because there's a risk premium. They allocate to bonds because there's a risk premium. They allocate to corporate bonds because there's a credit risk premium. Merger Arbitrage is very defensively to me, a risk premium, and yet almost no one has it in their portfolio, because I think the way it's typically packaged, which is basically a cash plus strategy. You're earning T-bills plus the merger risk premium, is just less, especially over the last decade where T-bills were giving you nothing, is just less attractive from a total return basis.

And from that line item perspective it is going to stick out to clients. When you take the return stacking approach like we do, where we carve off the risk premium element of Merger Arbitrage and stack it on top of the bonds, and you put that in a single line item, I think the return of that line item is a lot easier to hold for investors over the long run, is going to rhyme a lot more with what they expect to see in their portfolio, but still gives you that potentially really benefit breadth, right, expanding the set of risk premium that a client is allocated to. And so again, particularly in an environment like today where you are seeing credit spreads compressed to multi-decade lows, I think it's a timely period to explore how you can diversify beyond the credit risk premium.

These ideas that we're bringing are nothing new or novel, and there's something that's existed in the institutional space and been used with great success for a long time. And so all we're hoping to do is take that idea and bring it down and make it available, for lack of a better phrase, to democratize access to the idea.

So going back to this idea of how do you find diversification in your portfolio? We'll use the cliche example of a 60/40 investor. A lot of people over the last decade have pushed from moving from a 60% stock, 40% bond portfolio to something that's 50% stock, 30% bond, 20% alternative. And it may look great on paper over a multi-decade period, but the reality is behavioral time is a lot more like dog years.

You underperform for three years in a row and to the client it's going to feel like 21, and it's hard for them to stick with. And it's why you tend to see these really big measured behavior gaps in these alternative asset class categories, where the investment return tends to be several hundred basis points higher than the realized investor return, because they end up performance chasing in and out of these categories because it's hard for them to stick with.

Return stacking is just an idea that came from the institutional space called portable alpha that's been around for 40, 45 years, right, and what we're ultimately trying to do is use the capital efficiency that exists in a lot of these strategies, whether it's Managed Futures or Merger Arbitrage or Carry or you know, whatever it is, to layer those alternative strategies on top of the core stocks and bonds, so that instead of going from a 60/40 to a 50/30/20, they can go from a 60/40 to a 60/40/20.

And now the number sums up to more than a hundred, and they're adding these alternatives as an overlay to the core stocks and bonds that they expect to retain, which can help reduce the tracking error of their portfolio to those things that clients are most behaviorally sensitive to.