In “An Introduction to Merger Arbitrage,” Roy Behren and Michael Shannon examine merger arbitrage as an investment strategy that seeks to profit from the successful completion of corporate mergers and acquisitions. This approach involves purchasing the stock of a company being acquired and, in certain cases, shorting the stock of the acquiring company. The goal is to capture the spread between the current market price and the deal price offered by the acquirer.

Merger arbitrage is characterized by its focus on deal-specific factors rather than broader market movements. The returns are driven by the outcomes of individual transactions, which are influenced by regulatory approvals, shareholder votes, and other idiosyncratic risks. This results in a low correlation with traditional asset classes, making merger arbitrage a potential tool for enhancing portfolio diversification and improving risk management.

The authors provide empirical data to illustrate the performance characteristics of merger arbitrage strategies and their impact on portfolio metrics.

Past performance is not indicative of future results. Source: Morningstar Direct and Virtus Performance & Analytics. All data calculated over a 20-year time period (1/1/04–12/31/23). See page 7 for glossary and index definitions.

This figure compares a traditional 60/40 portfolio (60% S&P 500 Index, 40% Bloomberg U.S. Aggregate Bond Index) with an alternative portfolio that allocates 10% to merger arbitrage strategies, represented by the Morningstar U.S. Fund Event Driven Category Average. Over the 20-year period, the alternative portfolio exhibited a slightly lower annualized return but achieved reduced volatility, as indicated by a lower standard deviation and a lower beta relative to the market. The maximum drawdown was also smaller, suggesting enhanced risk-adjusted performance.

Past performance is not indicative of future results. Source: Morningstar Direct and Virtus Performance & Analytics. Time periods reflect the five largest S&P 500® Index drawdowns using peak to trough performance. Merger Arbitrage Strategies’ performance during periods represented are annualized for periods longer than 12 months and cumulative for periods shorter than 12 months. Merger Arbitrage Strategies represented by the Morningstar U.S. Fund Event Driven Category Average.

The figure highlights the performance of merger arbitrage strategies during the five largest S&P 500 Index drawdowns over the past two decades. In each instance, merger arbitrage experienced significantly smaller drawdowns compared to the broader market. For example, during the 2008–2009 financial crisis, the S&P 500 Index fell by -52.52%, while merger arbitrage strategies declined by -26.05%. This resilience demonstrates the potential of merger arbitrage to act as a defensive component in a portfolio, providing downside protection during periods of market stress.

Merger arbitrage aligns well with the principles of return stacking, which involves layering multiple uncorrelated return streams within a single portfolio to enhance capital efficiency and improve the risk-return profile. By incorporating merger arbitrage, investors can add a return source that is largely independent of traditional equity and bond markets.

This strategy can also complement portable alpha approaches, where the goal is to generate alpha—excess returns above a benchmark—without increasing beta exposure to the market. Since merger arbitrage returns are driven by deal-specific factors, they can provide alpha that is uncorrelated with market movements, aiding in risk management and volatility reduction.

The low correlation and unique return drivers of merger arbitrage make it a valuable addition to a diversified portfolio, potentially enhancing overall performance while mitigating risks associated with market downturns.

Roy Behren and Michael Shannon’s exploration of merger arbitrage presents a compelling case for its inclusion in investment portfolios. The strategy offers the potential for diversification, reduced volatility, and improved risk-adjusted returns by focusing on specific corporate events rather than broader market trends. When integrated into return stacked portfolios, merger arbitrage can contribute to greater capital efficiency and resilience, aligning with modern approaches to portfolio construction and optimization.