Bond Proxy For The Win?

The catalyst for this post is the following chart I saw on Twitter.

We've been talking about merger arbitrage as a bond proxy in the various places where I've blogged and written for more than 10 years. Here's maybe a more practical comparison via Portfoliovisualizer. Portfolio 1 is 60% SPDR S&P 500/40% iShares Aggregate Bond ETF (AGG) and Portfolio 2 is 60% SPY/40% Merger Fund (MERFX). MERFX is a client and personal holding.

 

The chart does not include this year's bear market. The results are essentially identical. To the extent investors uses bond exposure to help offset or manage equity volatility, they got that from MERFX and I'm sure we'd see very similar back testing from most merger arbitrage funds. Now, 2022.

 

Portfolio 1 is down 16.84% versus only 10.37% for Portfolio 2. The qualitative difference between the ten years ending 2021 and this year is the consequence for interest rate risk. AGG of course takes direct interest rate risk being a bond portfolio with a duration that is usually 6-7 years which isn't even that far out really versus merger arb which doesn't take direct interest rate risk. 

I should note there is theoretical risk to merger arb if crazy things in the bond market impacts deal financing. I've seen that come into play for short periods a couple of times but have never seen it persist. Yahoo Finance has MERFX up 0.81% YTD and at its low for 2022 on June 16 it was down 3.06%.

It's been so many years that I don't recall where I specifically learned about merger arb but it was long before I first added it to client portfolios shortly after the Great Financial Crisis. Bond yields seemed crazy low to me so finding low vol diversifiers that could function as bond proxies made sense and the strategy has behaved as expected or hoped for.

I write all the time about trying to understand what expectation a fund is trying to set, what should it do or look like. MERFX has performed as expected, not to the basis point of performance but in terms of what it should look like. As we've been framing it lately, it should look like a horizontal line that hopefully tilts upward. I would argue the ARK Innovation Fund (ARKK) has met its expectation of being a live by the sword/die by the sword type of fund. It went up much more than the market and this year has gone down more than the market. It's hyper-volatility beta and that's what it has done. 

The other day we took a quick look at the Noble Absolute Return Fund (NOPE) which dropped 20% in just a few days. I don't think the name including absolute return does a good job of setting any sort of expectation. 

From the top down, I guess the process here is isolating some sort of risk to markets or your portfolio more narrowly and then seeking out ways to protect against the consequence of that risk in case you're right. I feel like this example we keep using with interest rate risk was kind of an easy one in part because if I can see it so can anyone else. Also just in nominal terms, interest rates were lower than we'd ever seen and kept going lower. It was not trying to time anything it was about isolating a risk that would cause a lot of pain if, reiterate if, there was ever a consequence. It took until 2022 for there to be a consequence. While we waited we got something that looked a lot like the aggregate bond index. 

Who knows when it will make sense for investors to take on duration risk again. Speculators maybe already are doing so but for me, for now, any sort of duration remains a source of unreliable volatility which is not something that I think marries well with offsetting or managing equity volatility.