Free Money? No Thanks
March 24, 2021 — One year ago, the global pandemic spread rapidly and markets were reeling. Investor fear was palpable and selling pressure was extreme. March 23, 2020, ultimately marked the bear market nadir, in which the S&P 500 suffered a -35% drop in a record amount of time.
Put Out the Bucket
I remember the date of March 23, 2020, closely, not because it marked the bottom of the fastest bear market in history, but because it was supposed to be the launch date of the Accelerate Arbitrage Fund (TSX: ARB). Given the outstanding opportunity set at the time, I was keen to launch ARB and capitalize on those exceptional returns available for investors. At the time, I wrote:
If you review the evidence, it isn’t difficult to see that the current market environment for certain asset classes is at least as good as, if not better, than the last fat pitch lobbed to investors during the great recession between late 2008 and early 2009. If you recall, it didn’t matter all that much which asset class an investor bought, only that they were invested. However, allocating to the right asset classes during the recession had a material effect on investor outcomes. As one of the greatest investors of all time said about investing in a market panic, “opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” Eleven years after March 2009, it appears to be raining gold once again.
- The Paradox Of Choice: What To Do When It Rains Gold, published March 26, 2020
In March 2020, it was raining gold. There was literally free money lying around in the markets if one knew where to look.
The problem with “free money opportunities” is that they are only available when no one wants them.
The notion of no one wanting free money opportunities when they exist intuitively makes sense. For an investor to buy a free money opportunity, another one needs to sell. If market participants were rational, this transaction would never happen. However, when markets are overwhelmed with fear, some investors do irrational things. Enterprising investors can capitalize on this.
Unsurprisingly, on March 23, 2020, there was effectively no interest in free money opportunities or double-digit return investments with low risk. Markets were plunging and wallets were closed. The unfortunate aspect regarding truly exceptional investment opportunities is that they usually exist because people are too scared to invest in them. We ultimately had to delay the launch date of ARB because we had zero investors to seed the fund to launch on March 23, 2020, given everyone was too fearful. Fortunately, markets bounced double-digits and we were able to launch the fund two weeks later with one small seed investor.
It May be Time to Put out the Bucket Again
During the great bear market of 2020, the Accelerate SPAC Index dropped just -6.6% peak-to-trough. Free money opportunities were abundant and those with the intestinal fortitude to invest at the time were rewarded handsomely. With respect to the SPAC arbitrage opportunity set back on March 23, 2020, I highlighted “Double-digit returns with T-bill risk. What’s not to like?”
Fast forward to today. The Accelerate SPAC Index peaked on February 19, 2021, and has fallen -11.4% since, nearly double the drop of March 2020. Investor euphoria for SPACs has turned into despondency and disgust. The key difference is this time, it is not the economy and fear that has blown out SPAC arbitrage spreads. There has been a flood of SPAC IPO issuance, and that has put tremendous pressure on prices. Econ 101 basics indicate that when supply exceeds demand, prices fall, and prices have fallen more than they did one year ago.
Source: Accelerate
Arguably, the current environment for SPAC arbitrage is as attractive as that of March 2020.
We see a similar opportunity set in the SPAC market today as free money opportunities abound, with 68 SPACs trading at or below $9.75:
Source: Accelerate
The way that SPAC arbitrage works is that a blank check company holds $10.00 per share in trust. This $10.00 that is held in trust invests in short term Treasury bills. If a SPAC does not complete a business transaction within two years, the SPAC shareholder is returned $10.00 plus accrued interest. If a SPAC strikes a business combination, the shareholder receives the option to redeem their shares for $10.00 plus accrued interest.
SPACs trading below $10.00 represent a free money opportunity because the investor is virtually guaranteed $10.00 plus accrued interest as long as they can hold until maturity and redeem their shares. In addition, the investor has upside optionality should a SPAC announce an attractive business combination that sends its shares above its $10.00 plus accrued interest trust value.
Risk Management and Active Management
The problem with free money opportunities is that an investor needs two things in order to capitalize on them:
- Capital to deploy.
- Knowledge to know how to deploy it.
In inefficient markets such as SPACs, this is where active management pays off.
The problem with passive management in inefficient markets is the inability to be opportunistic and capitalize on the inherent inefficiencies to pursue the highest return potential investments.
The disadvantage of passive management was on display over the recent SPAC market correction.
ARB was able to outperform all other SPAC-focused ETFs, including SPAK, SPCX and SPXZ, by reducing exposure during the February SPAC market frenzy. As I wrote on February 15, 2021:
Given the rally in the SPAC market, the ARB portfolio management team has dramatically paired back SPAC positions. ARB is now the most conservatively positioned since its inception.
Source: Bloomberg
Having the market knowledge and proprietary analytics to trade with conviction and manage risk, in addition to having the ability to capitalize on market inefficiencies, allowed ARB to dramatically outperform its comparables during the recent drawdown.
Not only was ARB able to outperform its peers throughout the recent market correction, but we were able to utilize our substantial excess buying power to capitalize on the current exceptional opportunity set. Risk management allows us to buy aggressively when it starts raining gold. We have been investing.
If Not a Bucket, then at Least Consider a Thimble
In March of 2020, free money opportunities emerged because the coronavirus pandemic threatened not only the global economy, but our livelihoods as well. It ultimately proved to be an exceptional buying opportunity.
In March of 2021, free money opportunities emerged because market participants got greedy and issued too many SPACs, causing prices to fall precipitously.
The good thing is that investors now get another crack at it.
I’m telling you where the free money is, all you have to do is pick it up.
-Julian
