Equity volatility and the SPAC arbitrageur

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Alternatives spotlight

by Justin Lenarcic Senior Global Alternative Investment Strategist

• 2020 witnessed the rapid adoption of Special Purpose Acquisition Companies (SPACs) alongside a new regime for equity volatility.
• Both conditions — when combined — elicit a great environment for SPAC arbitrage, where skilled investors can capture the movement in the common stock and warrants of SPACs around deal announcements.

Every few years, capital markets have experienced a transformational event that directly affected hedge fund strategies. From junk bonds to collateralized loan obligations (CLOs), exchange traded funds (ETFs) to server colocation, technology and creativity have combined to create a new “regime” of opportunity for active management. Rarely, though, have we seen years in which investment innovation coincided with a significant change in the macro trading environment. 2020 was such a year. Not only did we witness a new equity volatility regime, but we also witnessed the maturation and adoption of Special Purpose Acquisition Companies (SPACs). While seemingly unrelated, we believe both will have a meaningful impact on hedge funds and likely usher in — the potential for compelling opportunities for arbitrage in 2021 and beyond.

The classic definition of arbitrage is simultaneously buying and selling similar or related securities, seeking to profit from potential mispricing in those securities while mitigating downside risk. If one takes that simplistic concept and applies it to capital markets, it’s easy to see why arbitrage can be an important tool within a hedge fund manager’s toolbox. Whether it’s fixed-income arbitrage (which seeks to capture small differences in global interest rates and yield curves), statistical arbitrage (which uses quantitative models in an effort to capture the tendency of securities to mean revert), or merger arbitrage (which trades the deal spread for mergers and acquisitions), we believe there is potential for an abundance of opportunities to capture mispriced securities while mitigating downside risk. But the one critical ingredient for successful arbitrage is mispriced securities. And what help cause mispricing? Volatility!

Higher equity volatility regime still in place

 

Sources: Bloomberg, Wells Fargo Investment Institute, January 31, 2021. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Please see end of report for index definitions. 

We believe that equity volatility — as defined by the Chicago Board Options Exchange Volatility Index (VIX) — entered a new and higher “regime” in early 2020 primarily as a result of the coronavirus pandemic. From mid-2012 until that point, monthly VIX readings were generally well below their long-term average of 19.5, save for a few brief spikes. For hedge funds, volatility is like soup — they like it not too hot, not too cold, but just right. This “goldilocks” volatility environment that characterized 2020 and — so far — 2021 is one key reason why we’ve seen strong returns from strategies predicated on optionality, such as convertible bond arbitrage. Derivatives are highly sensitive to volatility, and strategies that can skillfully trade these securities have potential for strong returns. 

Alongside higher equity volatility came a rather sudden and drastic increase in SPAC issuance. Here is where we see one of the more exciting opportunities for hedge funds this year, especially those that have a background in mergers and acquisitions (M&As) as well as derivatives trading. Because SPAC units include common shares and an equity warrant, and because the value of the warrant is generally expected to affected by volatility, we believe have an opportune environment for the nascent “SPAC arbitrage” strategy. We began to see funds generally increase their exposure to this sub-strategy in the middle of last year, and we anticipate the allocations to grow this year, especially given the feverish pace of SPAC initial public offerings (IPOs). While SPAC arbitrage can take several forms, one we have seen more frequently is hedge fund managers purchasing SPAC shares at a discount before a deal is announced. During this time, they seek to earn a small yield from the cash held in the trust while potentially gaining incremental return from the closing of the net asset value (NAV) discount. Generally we would expect SPACs shares to trade above NAV if the market views a deal as positive, at which point we would expect arbitrageurs to sell their positions. If the deal is not well-received by the markets, we anticipate the arbitrageur to redeem their SPAC shares upon shareholder vote for little to no loss. Upside optionality with the ability to mitigate downside risk — the quintessential arbitrage trade!

So far in 2021, 139 SPAC $44 billion in SPAC IPOs have been issued. This comes after a record year in 2020, when 231 or $81.5 billion in SPAC IPOs were issued.  With little indication that the SPAC frenzy is slowing — and our expectations for higher than average volatility to continue — we believe the environment for SPAC arbitrage should be favorable this year.

Equities

by Ken Johnson, CFA Investment Strategy Analyst

• Emerging market equities recently closed above their 2007 peak.
• Our outlook for better trade dynamics, stronger global growth, and a persistently lower U.S. dollar should potentially benefit the asset class.

Emerging market equities reaching new highs

In recent months, we’ve upgraded Emerging Market (EM) Equities from unfavorable to favorable. Since then the MSCI Emerging Markets Index (proxy for emerging market equities) hit a new all-time high, surpassing its 2007 peak. We believe several factors have contributed to the asset class’ success. 

Foremost, Chinese markets, as measured by the MSCI China index extended its performance lead from last year, after it bypassed deep declines experienced by other developing countries. Exports have hit a recent snag; however, new export order data remains expansionary and we believe points to continued strength. 

More broadly, a weaker dollar has supported higher EM equity prices — the two have historically moved in the opposite direction. The U.S. dollar has lost some of its appeal as international growth has become more competitive, U.S. rates have fallen, and U.S. fiscal debt has risen. Improvements in global coronavirus containment have helped to reignite investor sentiment toward risky assets. All the while, higher crude oil and material prices have enhanced investors’ palates toward commodity-producing equity firms found in Latin America, Emerging Europe, and Africa countries. 

Unbalanced vaccine distributions across emerging countries we believe leave them more vulnerable to COVID-19 outbreak waves than the wider global economy. However, as we look ahead, we expect improving trade, strong global growth, and a persistently lower dollar should continue to benefit the asset class.

MSCI EM Index closes above its previous peak

Sources: Wells Fargo Investment Institute, Bloomberg, February 17, 2021. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. See end of report for index definition.

Fixed Income

by Brian Rehling, CFA Head of Global Fixed Income Strategy

• We favor the intermediate portion of the yield curve for the available yield pickup (as part of a well-diversified bond portfolio). We would caution investors to avoid overexposure to longer-maturity positions, given the higher interest-rate risk typically inherent in such holdings.
• Currently, we recommend that investors maintain a neutral duration relative to their individually selected benchmarks. For reference, the Bloomberg Barclays U.S. Aggregate Bond Index currently has a duration of 6.18 years.

A yield curve bear

In recent months, longer-term interest rates have been moving higher. Higher rates often lead to negative price performance on interest-rate-sensitive fixed-income securities — thus the bear nature of higher rates on performance. During this period of increases in long-term rates, short-term rates have remained anchored by the Federal Reserve’s (Fed) zero lower bound. This dynamic of higher long-term rates with short-term rates unchanged has led to a steepening of the interest rate curve, a “bear steepening”. The interest rate curve is a good reflection of the market’s expectation of future economic activity. A flat or negative interest rate curve generally indicates that challenging economic times may be ahead, while a steep interest rate curve tends to suggest that the market expects economic activity to improve.

We do not expect the Fed to change its stance on short-term rates for some time, thus short-term rates are unlikely to see much movement in yield. However, we do expect longer-term rates to continue to move gradually higher over time. This should lead to an extended bear steepening environment in fixed-income rate markets.

A bear steepening rate environment can be difficult to manage for many fixed-income investors. In the current environment, high-quality, short-term securities offer little in the way of yield making navigating this bear steepening cycle even more challenging. Maturities in the five- to seven-year range continue to offer a yield pick-up over short-term rates, are less rate sensitive than longer term maturities, and — we think — offer investors the most value on the curve today.

Real Assets

by Austin Pickle, CFA Investment Strategy Analyst

“When we are no longer able to change a situation, we are challenged to change ourselves.” — Viktor Frankl

• Oil’s recent rally and the potential for increased supply are key rationales for our downgrade of Energy commodities from favorable to neutral.
• Improved demand, inventory levels, and relative performance prompted our Agriculture commodity upgrade from neutral to favorable.

Showcasing shifts in commodity sector guidance

We upgraded Agriculture commodities from neutral to favorable, and we downgraded Energy commodities from favorable to neutral in our February 12 Real Assets Quarterly Guidance report. Today we highlight those changes. 

Oil prices have benefited from accelerating global economic growth and restrained supply — in the U.S. as well as Saudi Arabia and the rest of OPEC+.  OPEC alone has over 7 million barrels per day of spare capacity or idled production that could be brought online in short order. Yet, oil’s recent rally could threaten that restraint. We suspect that oil producers — including OPEC+ members — are anxious to capitalize on higher prices and are chomping at the bit to increase production. We heard grumblings to this end when West Texas Intermediate (WTI) price was below $50 during the January OPEC+ meeting, where some members pushed to increase production quotas. What will happen at the upcoming March 4 meeting if WTI is above $60? The increased likelihood of additional oil supply at these price levels is a key rationale for our Energy commodities downgrade.

Agriculture commodities had been a perennial commodity laggard since 2016, yet we believe that may be changing. The group has outperformed in back-to-back quarters and seems to have put in a significant relative performance bottom. Demand has improved and inventories have drawn down from extended peak levels, driving recent outperformance. We suspect these trends will continue, and we have followed up on our September 2020 Agriculture upgrade to neutral with another upgrade to favorable.

Performance since WFII’s favorable commodity rating (March 12, 2020)

Sources: Bloomberg, Wells Fargo Investment Institute, February 17, 2021. The commodities listed are the components of the Bloomberg Commodity Total Return Index.

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