This column is part of a new collection of our “Structure Matters” series of interviews with leading ETF and index industry figures. They are conducted by Dan Weiskopf, a portfolio manager at New York-based Access ETF Solutions LLC. In today’s piece, Weiskopf interviews Salvatore Bruno, chief investment officer of IndexIQ, the hedge fund replication ETF sponsor that was recently acquired by New York Life.
In this interview, Weiskopf mines data showing mergers and acquisition activity is at all-time records in the U.S. That brought into focus the IQ Merger Arbitrage ETF (MNA | D-89), a $131 million ETF that targets the red-hot M&A market, and also how that MNA is likely to shift as the economic recovery evolves.
Dan Weiskopf: According to data from Thomson Reuters analyzed by PricewaterhouseCoopers, the U.S. saw 4,654 M&A deals worth about $875 billion from the start of the year through May 31. What key factors, besides cheap money, are driving M&A activity?
Salvatore Bruno: Merger activity over the last 12-18 months has accelerated. While it is difficult to point to any one factor, there are a number of factors that are contributing to the increase. I agree that the combination of cheap money both in the form of borrowing costs to fund cash for leveraged buyout deals and a stock market that has touched record highs has increased M&A activity. Weakness in the economy has also increased activity—companies looking to increase earnings per share through acquisitions seem to be downplaying the impact of weaker organic earnings.
In health care, many announcements have been made by cash-rich, large pharmaceutical companies looking to bolster their drug pipeline as patents on existing drugs expire. Also, companies that were able to complete their tax inversion prior to the Obama administration’s move to deter inversions in late 2014 now have a competitive advantage versus other companies that were blocked. Companies such as Actavis have been particularly aggressive in the M&A space, having already moved their headquarters to Ireland from New Jersey.
Weiskopf: How should investors expect your strategy to adjust when low-cost money and central-bank stimulus ends in the U.S.?
Bruno: The mix of stock and cash in deals has been fairly constant with approximately 60 percent coming from cash and 40 percent from stock. As cash becomes more expensive, there is the potential for more stock to be used in deals and/or overall deal activity to slow. However, as an increase in interest rates is likely to lead to a slowing of economic growth with a commensurate effect on corporate earnings, there could be a renewed focus on M&A as a means to grow EPS.
Weiskopf: Your M&A strategy is about 83 percent U.S. and 17 percent Europe. What factors might lead to a more global weighting, or should investors look at this strategy as a U.S. allocation?
Bruno: The strategy has historically been more weighted to U.S. deals relative to the rest of the world. However, there are two effects at play here, and it’s important to understand these factors to understand how the allocations are determined. First, we have to look at the number of announced deals. Historically, there have been more deals announced internationally than domestically.
This would argue for a larger weight outside the U.S. However, one also needs to take weighting into consideration. When you look at the size of the deals in dollar terms, historically there has been a greater dollar value of deals in the U.S. than outside the U.S.
Our portfolio allocates weight to the deals based on liquidity [or average dollars traded] of the company. Given the high and positive relationship between market cap [size] and liquidity, it’s not surprising that we will have more of the portfolio allocated to U.S. rather than to non-U.S. deals.
If we were to see a real acceleration in the number or size of non-U.S. deals, the portfolio would likely have a greater allocation in the developed international markets.