T'is the season for portfolio rebalancing
A common time to rebalance a portfolio is when a new year arrives. Rebalancing keeps risk down. If an investor’s target allocation for stocks is 60% and they let the weight drift up to 85%, it could get rather painful when the next bear market arrives.
The usual way to rebalance during bull markets is to increase bond holdings relative to stocks until their targeted precentage is restored in a portfolio. But people now say bond yields are too low and inflation too high. And bond prices are so high, they have nowhere to go but down, they say.
Many investors are going into dividend stocks as an alternative since they still have high yields. But if the bear market is a serious one, dividends could be cut or suspended. And prices of dividend stocks could see some big declines.
I still own bonds and dividend stocks but instead of using them to rebalance, I am getting into an approach that Warren Buffett used in his early days: merger arbitrage. I know this technique is not for everybody. But what I like is that when it’s properly executed, one can earn positive returns regardless of economic and market conditions.
Merger arbitrage arises when the executives of a company accept a takeover offer from another company and their stock then trades at a discount to the bid price during the months waiting for approvals from shareholders and government bodies.
A large majority of the bids succeed, and they are not too hard to spot. The merger arbitrager will (in all-cash offerings) simply buy the discounted shares of the acquired company and ride the move up to the takeover price as the deal heads toward closing. The appreciation should occur even if the economy and market are tanking.
This line of thought led me to buy shares in Shaw Communications in November, as noted in Investing in the shadow of bear markets. They were trading about 10% below the takeover price Rogers Communications was bidding on an all-cash basis. I also recently bought Pretium Resources to arbitrage the bid from Newcrest Mining.
Another bond substitute is SPAC arbitrage. I know just about everyone thinks SPACs are garbage. True, when they make acquisitions, they usually underperform - as the stats show. But before the acquisitions, SPACs can be a source of virtually riskless arbitrage gains - with a warrant attached for a shot at the occasional big score.
A SPAC goes public by issuing units consisting of shares and warrants stapled together (can be separated several weeks after the IPO). The IPO unit price is always set at US$10, and the proceeds are held in trust in short-term government bonds.
If an acquisition is not made on time, or the proposed acquisition is not to an investor’s liking, they can unstaple the units and redeem the shares for US$10 plus interest or sell them in the stock market if priced higher. The warrant can be sold in the market right away or kept for the off-chance they soar in value.
Or investors can just simply buy the shares of a pre-acquisition SPAC trading in the market under US$10 and redeem them later on. So, for example, if a SPAC’s share is purchased at US$9.70 and redeemed a year later at US$10 plus interest, this is a pretty certain gain of 3.1%. It could be higher if the shares are sold on the market in the event their price has been bid above US$10.
In sum, a small positive arbitrage return is virtually assured with the potential for bigger gains. A small positive return may not be too appealing to investors immersed in a bull market, but in a bear market, it will be quite appreciated.
The SPAC market is subject to swings in supply and sentiment, which can drive prices above or below NAVs. As can be seen in the accompanying chart, SPACs were trading at a premium as high as 25% during the frenzy of early 2021 but now they are trading at a discount. That opens the door for arbitrage trades - with a shot at the occasional big winner thanks to the warrants.
Source: Julian Klymochko, Accelerate Financial Technologies
“The current setup seems quite prospective for SPAC investors,” notes Julian Klymochko, CEO of Accelerate Financial Technologies in a Dec. 23 article on his company’s website. “The average SPAC yields 2.3%, representing a 160 basis point premium to 2-year T-bills.”
Earlier this month, I went for it and bought an ETF (Ticker: ARB) that focuses on SPAC arbitrage. It buys SPACs during the IPO, which offers additional opportunities for gains. Of note: since March, most SPACs have overfunded their offerings to boost NAV to as much as $10.25 a unit while keeping the sale price at $10. Also, when the shares and warrants are split out of the units in the weeks after the IPO, their combined value can settle at a premium to the IPO price.