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Because hedge funds tend to be market neutral, they have made it increasingly difficult for traditional portfolio managers to hide behind comparative performance matrices (such as Standard & Poor's 500 Stock Index) in times of flat or declining markets (such as 2000-2002). Of particular interest among hedge funds is the merger arbitrage hedge play. This article examines the various forms of merger arbitrage based on cash transactions and stock transactions. The important message is that by carefully assessing the likelihood and time period for consummation, appropriate returns can be earned in different types of market environments. [G2, G3]
For the first five years of the current decade (2000-2004), common stocks showed a cumulative decline of 14.7% as measured by Standard and Poor's 500 Stock Index. This performance is quite a disappointment to investors who have been trained to expect at least a 10% annual return by Ibbotson and Associates and other market historians. Although the double-digit annual return is over the long-term, this is small consolation to the investor in need of current returns. As a more dramatic example of what can happen in the equity markets over a shorter time period, the NASDAQ Index was down 52.06% in 2000-2001.
I. Hedge Funds
In such a market environment, it is not enough for professional money managers to merely state, "We had losses, but are proud of the fact we equaled or perhaps exceeded the popular market averages." An important axiom of Wall Street is that investors cannot "eat competitive market performance."
Thus, it becomes necessary for professional money managers and try to identify market neutral investment outlets that provide adequate returns-regardless of the direction of the stock market or the economy. It is in such an environment that the one trillion dollar hedge funds industry has evolved. The intent of such funds is to design market neutral strategies that take advantage of market imperfections (and superior trading strategies) to earn a positive return irrespective of which direction the market is moving. (As will be demonstrated in Exhibits 2 and 3, this has generally been the case.) Hedge funds make use of the arbitrage techniques, put-call option combinations, long-short strategies, etc. in order to generate their returns.
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