THEN AND NOW The lack of serious inflationary pressures in the U.S. in recent years created scant demand for inflation-linked products. Innovation was confined to Europe and to the wholesale derivatives markets, where inflation swaps, economic derivatives and CPI futures gained ground. But since September’s spike in CPI, attention has once again turned to this product line, with interest in TIPS and other retail products growing.

TIPS remain one of the few direct ways to gain a direct hedge for inflation, short of participating in the wholesale inflation derivatives markets (using inflation swaps, economic derivatives or CPI futures, for example). Other popular inflation-hedging strategies, such as direct investments in commodities and investments in commodity futures contracts, only provide a second-order exposure, and expose investors to commodity market risks and, in the case of companies, business risks. Inflation-linked structured products remain very popular in Europe, where the memory of interwar and postwar hyperinflation remains vivid, but they remain fairly rare in the U.S.

3. Merger Arbitrage Hedge Funds
Unlocking the M&A Bounty June 2004, page 90.
Despite the barrage of mergers and acquisitions in 2005, merger arbitrage hedge funds performed much as they have in the past. They returned 3.99 percent from the beginning of the year to the end of August, according to the Barclay/Global HedgeSource merger arbitrage index.

The merger arb investing style has failed to match the upward trajectory of activity in the M&A market, but its proponents say it remains profitable. Merger arb seeks to profit from acquisitions by betting on their chance of success. A fund seeking to bet that a deal will succeed, for example, would accumulate the stock of the company being bought and short the stock of the acquirer, under the assumption that the two will converge as the deal nears consummation.

THEN AND NOW Returns from merger arbitrage (also called risk arbitrage) did not follow M&A volumes upward in 2004 and 2005, as many had hoped. Some blame the preponderance of private equity firms in these transactions; merger arb backers say that no, the strategy remains viable even where private firms are the buyers, and its performance is in line with its modest return, low-risk goals.

Some observers believe merger arb strategies are hamstrung somewhat by the fact that private equity firms are now driving the lion’s share of M&A activity. Since these funds have no listed shares, arb funds cannot short their stock.

But the arb funds themselves dismiss this. “The explosion in cash held by the private equity firms is one factor leading to the high level of deal activity,” agrees John Orrico, portfolio manager with the Arbitrage Fund, based in Rye, N.Y. However, he notes, “About one-half of all transactions announced are cash only, but since we receive cash as consideration, there is no need to sell short any shares of the acquirer.”

Orrico adds that private equity firms do bring an additional risk to these deals because of their use of leverage. “We examine the financing needs of each deal and pay close attention to the fixed-income markets to gauge the ability of these private buyers to raise the necessary funds in order to complete the transaction,” he says.

The merger arbitrage style remains a low-volatility, moderate-return strategy. In 2004, for example, arbitrageurs had hoped for juicy payouts, given the number of mega-deals beginning to appear, such as JP Morgan Chase’s $60 billion acquisition of Bank One. In February of that year the value of transactions announced globally rose to $238.6 billion, the highest level since October 2000. Yet the Barclay/Global HedgeSource merger arbitrage index registered a return of just 5.2 percent. Net of inflation, that is a very modest return, given hedge fund liquidity constraints and risk. But proponents insist returns, never spectacular, should be consistent.