With the election now only two days away and most choices likely set, I’m sure that many of you are ready for at least a brief respite from the crescendo of related coverage. In that vein, we’re taking a break from our election series this week, but for those still inclined you may want to check out our previous two posts: “Mitigating Election-Driven Volatility in Your Portfolio” and “The Hidden Election Candidate – ESG”. This past week we also wrapped up our 4-part “Best Practices in Hedging” webinar series. No worries if you missed any of these webinars, you can view the full recordings on our website.
The Typical Merger Trade
This boom in M&A is a playground for a risk arbitrageur. Leading academic research suggests that richly valued companies typically signal a peak in their valuation, especially when they use their stock as currency to pay the acquisition price. Thus, a merger-arbitrage strategy for a stock-for-stock deal has the investor buying the target’s stock and short selling the acquirer’s to lock in the deal spread.
An Alternative for an AMD acquirer short
If you think the semiconductor industry has been on a tear, take a look at AMD’s stock price performance since the beginning of 2019:
What risks should we hedge?
Interestingly, 72% of AMD’s stellar 272% S&P500 outperformance shown in the prior chart is attributable to factors such as Momentum, Growth, and the Semiconductor industry. Thus, our view on AMD’s total performance in the future should likely be decomposed into:
The chart below shows AMD’s historical and current predicted active risk (vs S&P500) of 45.54%, decomposed into factor and alpha components. This means that an investor shorting AMD is actually betting against:
With the election around the corner and high likelihood of significant market volatility, we certainly would want to hedge out the factor risk but likely minimize our hedge on the risks associated with the positive drivers of AMD and the semiconductor industry.
Building an AMD SmartHedge™
Leveraging Omega Point’s Smart Hedge builder, we were able to design a basket hedge that replicates AMD’s factor risk using the following rules:
Backtesting the hedge
While past performance is certainly not indicative of future results, backtesting allows us to determine whether our process appropriately captures the factor characteristics of AMD, while avoids the idiosyncratic elements.
The combination of both reducing idio + sector risk allows the Smart Hedge to outperform the AMD hedge by almost 40% and the SMH ETF hedge by almost 12% over the backtest period.
For an investor looking to gain a dual benefit of (a) positive semiconductor trend and (b) merger premium returns can apply the AMD SmartHedge™ approach across the three other semiconductor deals. If this is an area you’re interested in exploring further, please contact us and we’d be happy to setup a time discuss these types of trades.
US & Global Market Summary
US Market: 10/26/20 -10/30/20
Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)
Please don’t hesitate to reach out if you’d like to learn more about building your own SmartHedge™ or find out more about the many other ways Omega Point can help advance your existing investment processes.