Arbitrage: Your Secret Weapon in Portfolio Diversification

November 25, 2023 — In making the case against investment portfolio diversification, people will point to the Forbes 400 list. At the top, you will see three individuals, worth over $100 billion each, who became the wealthiest in the world by buying into one stock and holding it for the long term.

Specifically, tech entrepreneur Elon Musk invested in the electric vehicle startup Tesla in 2004, becoming its largest shareholder. Then, in 2008, he installed himself as CEO, taking the company public in 2010 and creating the global leader in EVs. The majority of Musk’s wealth generation has come through his Tesla holdings.

In 1962, investor Warren Buffett began buying stock in an ailing textile manufacturer called Berkshire Hathaway after determining its shares were undervalued. Buffett bought shares in Berkshire with the idea that as the company closed its textile mills and freed up capital, there would be a tender offer at some point, and he could sell the stock for an arbitrage profit. The tender offer did not play out as he expected. However, by 1965, Buffett accumulated enough shares to take control of the company. Over time, he transitioned Berkshire Hathaway from textiles into a holding company and focused on compounding its growth. Nearly all of Buffett’s wealth has been created through investing in Berkshire Hathaway stock.

In the late 1980s, financier Bernard Arnault saw an opportunity in LVMH stock and acquired a large block of shares in the conglomerate. By 1989, Arnault had secured a controlling stake in LVMH and was appointed Chairman of the company. Under his leadership, LVMH became one of the world’s largest and most successful luxury goods conglomerates, earning him the top spot on the Forbes 400 list with a net worth of more than $200 billion.

All three of these investor-CEOs became the world’s wealthiest by focusing their investments on one bet, spurning the notion of diversification. Through a combination of luck, hard work, and business savvy, their bets worked out tremendously well and rocketed them to the upper echelon of the Forbes 400, each with a net worth north of $100 billion.

Nonetheless, for every Buffett, Musk, and Arnault, there are millions of investors and entrepreneurs who made a big bet and lost.

While maximizing risk is the key to getting extremely wealthy, minimizing risk is the key to staying wealthy.

For those who want to prudently grow their wealth, portfolio diversification through the spreading of investment risk across asset classes is crucial.

Much ink, both physical and digital, has been spilled debating the merits of portfolio diversification and the traditional 60/40 stock and bond portfolio. For the two-decade period up until 2020, the stock and bond portfolio produced great investment returns with relatively low volatility, as both stocks and bonds performed reasonably well, doing so with low (or negative) correlation. As all investors know, low (or negative) correlation across asset classes is the fundamental principle of diversification.

However, in recent years, stocks and bonds have been highly positively correlated, greatly reducing their diversifying features. In addition, before 2000, stocks and bonds were positively correlated more often than not. To put the nail in the coffin of the 60/40 portfolio, stocks and bonds both declined markedly in 2022, leading to double-digit losses for the 60/40 allocation. A double-digit loss in a year obliterates the credibility of a diversified, supposed low-risk allocation. An improved solution is needed.

A diversifying and volatility-reducing solution that many sophisticated investors utilize is arbitrage. Given its characteristics, including consistent returns, mitigated volatility, and low correlation to both stocks and bonds, arbitrage has served as an effective portfolio diversifier.

Since spring 2020, arbitrage has gained 42.5% (10.3% annualized), while stocks have gained 63.2% (14.5% annualized), and bonds have lost -10.1% (-2.9% annualized).

Source: Bloomberg

By taking some allocation from the fixed income portion of a balanced portfolio, which has hurt investors over the past several years, arbitrage has boosted the return of a more diversified portfolio of stocks, bonds, and arbitrage. Specifically, instead of the traditional 60/40 portfolio, adding a 10% allocation to arbitrage not only increased return but reduced volatility and mitigated the portfolio drawdown.

Since the spring of 2020, the 60/40 portfolio (blue line below) gained +15%, while the more diversified 60/30/10 portfolio that includes arbitrage (orange line below) gained +21%.

Source: Accelerate, Bloomberg

While bonds have ceased being a diversifier for stock portfolios, with a relatively high correlation of 0.53, arbitrage has served as a much more effective diversifier, with a correlation of just 0.13. Notably, arbitrage has a correlation with bonds of just 0.12.

Source: Accelerate

Given that a low (or negative) correlation is the leading characteristic of a portfolio diversifier, arbitrage stands out as a much better portfolio diversifier than bonds.

Nevertheless, while traditional asset exposures represent passive strategies, arbitrage is a very active investment solution because of its low duration and high turnover.

As for merger activity, last month was no exception. In October’s memo, Oil Giants Unite In Mega Mergers, we noted that “October was the busiest month for mergers and acquisitions in at least the past five years, with $155 billion of publicly-listed mergers announced in North America.”

In comparison, merger activity slowed markedly in November, with 8 public M&A transactions worth approximately $9 billion announced in the U.S. and Canada. The total deal value for the month was 94% lower than October’s record-setting pace.

For merger arbitrageurs, more excitement came on the closing side of the deal ledger this month. In November, eighteen deals worth an aggregate of $125 billion were completed. Broadcom completed its $69 billion acquisition of VMWare, representing a volatile and high-yielding merger arbitrage investment that ultimately padded arbitrageuer pockets with an above-average return. Just weeks ago, the market was pricing in a 50–50 chance of the merging companies solidifying Chinese approval and completing the transaction. As is typically the case, cooler heads prevailed, and the deal worked out as planned (although delayed, which seems to be happening more often these days), providing a 25% gross return to those who had the conviction that the merger would attain all approvals and close as expected.

As we look to year-end and 2024, we expect continued consolidation in the oil patch, along with steady activity in biotech M&A. We believe private equity activity will be slow, with interest rate-sensitive leveraged buyouts pulling back until central banks start cutting rates. As commodities and precious metals prices remain elevated, we would not be surprised to see an uptick in deal activity in the mining sector.

The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.

Each individual merger is assigned a risk rating:

• AA — a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
• A — a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
• BBB — a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
• BB — a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
• B — a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
• CCC — a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
• NR — a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.

The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.

* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.