June 26, 2020 – “I don’t have 10 to 15 years left to recover my losses,” Ophthalmologist Craig Sklar told the Wall Street Journal after selling much of his stock portfolio at a loss in the first quarter of this year as the coronavirus pandemic raged and markets collapsed.
Sadly, during the extreme stock market volatility between February and May when the S&P 500 suffered its quickest -35% plunge on record, nearly one-fifth of individual investors sold all of their equity holdings and over 30% of investors over the age of 65 unloaded all of their stocks in a panic.
Don’t Just Do Something, Stand There!
The clever Warren Buffett maxim, “be fearful when others are greedy and greedy when others are fearful,” is easy to recite in theory, however, in practice it’s far more difficult to follow. Investors were frozen with fear during the market plunge in March, and many chose to be fearful and panic-sell their stocks as markets bottomed, dreading spiralling losses. Unfortunately, those who panicked missed out on the subsequent nearly 40% rebound in the S&P 500.
Long-term investing in stocks has merit. Broad-based equity indices have returned about 8% per annum over a number of decades. The problem is, these long-term returns come with the occasional bout of volatility, sometimes exceptionally so. Large equity drawdowns amidst periods of extreme volatility pose a challenge to investors. Many become casualties of the human brain’s unfortunate psychological desire to reduce pain by exiting their falling investments and end up failing to harvest the attractive potential returns from long-term investing.
You CAN Eat Sharpe Ratio
There is a common adage in investing which states “you can’t eat Sharpe ratio.”
Sharpe ratio refers to an investment strategy’s return per unit of volatility. Theoretically, a higher Sharpe ratio is ideal, however, many investors complain that volatility is irrelevant to long-term returns, and thus Sharpe ratio does not matter in the grand scheme of things.
Generally, the management of risk and volatility comes with a trade-off in the form of lower long-term investment returns. If one has a long-term investing perspective (greater than ten years) in addition to the intestinal fortitude to have the equanimity (or obliviousness) regarding dramatic short term drawdowns in portfolio value, then the management of volatility likely isn’t worthwhile.
This thought experiment is theoretically sound. However, in real life, it falls apart pretty quickly. One only needs to look at the case of Mr. Sklar, and millions more like him, who sold their investment portfolio at a loss earlier this year in the face of a large decline in value.
Volatility management does matter if it keeps investors from making mistakes by veering off their long-term asset allocation plan. That is, you CAN eat Sharpe ratio.
Downside Risk Management with SPAC Arbitrage
In The Art Of SPAC Arbitrage is posited that “SPAC arbitrage is one of the lowest-risk investment opportunities out there. If done properly, there is little downside risk, assuming one isn’t forced out of the position at an inopportune time.” I also stated that SPAC arbitrage presents “equity upside combined with the risk profile of treasury bills.”
Given that a special purpose acquisition company only holds short-term treasuries and offers the option to redeem the shares for net asset value (“NAV”) at the end of the SPACs life, as long as an investor buys a SPAC at or below NAV, there is a baseline, low-risk arbitrage return. If an investor buys a SPAC at a discount to NAV, the investor will earn at least the yield of treasuries plus the NAV discount over the life of the SPAC (which is generally less than two years).
Many investors prefer to own short-term treasuries, given the low downside risk. The mitigated downside is what SPACs provide, given that they only hold treasuries and offer a redemption option at the SPAC IPO price of $10.00 plus accrued interest.
Downside protection comes in handy, especially in volatile markets, as we saw in Q1. This risk mitigation feature within a portfolio can help an investor from panic selling at the lows and disrupting their long-term financial plan. The best asset allocation is one an investor can stick with, and mitigating drawdowns allows investors to remain committed to their investments.
Where’s the Upside?
One criticism with short-term treasuries is that the yields are puny. It is tough to get excited about the 0.15% yield of a T-bill.
SPAC arbitrage addresses the criticism regarding low yields by presenting an investor with two potential return streams:
- Baseline scenario: The SPAC does not complete a business combination within its lifetime and liquidates, or the SPAC presents an unattractive deal and shareholders choose to redeem. Here, arbitrageurs earn a baseline return of treasury yield plus the SPAC’s discount to NAV.
- Upside scenario: The SPAC announces a business combination that the market is keen on and its price rises above its net asset value. This share price increase represents the equity upside scenario.
Lately, the market has been enamoured with SPAC deals. Speculators have been handsomely rewarding blank check companies that announce deals with surging share prices.
For example, on June 19th it was reported that blank check company Insurance Acquisition (“INSU”) was in talks to merge with private company Shift Technologies Inc., an online retailer for used cars. Given investors’ keen interest in the potential deal, INSU’s stock rallied from a -0.5% discount to NAV to a 15.4% premium. An arbitrageur holding INSU stock saw the prospective return go from a baseline 2% yield through redemption to a 16% gain overnight.
Source: Accelerate, BloombergOn June 19th, SPAC Tortoise Acquisition (“SHLL”) announced a business combination with private company Hyliion Inc., a manufacturer of electrified powertrain solutions for semi-trucks. Speculators did not hold back their excitement for the deal, bidding up SHLL stock from a -1% discount to NAV to a stunning 65.5% premium. All of a sudden, a pedestrian 2% annualized expected return turned into an instant absurd gain.
Source: Accelerate, BloombergIt isn’t just Insurance Acquisition or Tortoise Acquisition stocks that investors have rewarded. Nearly every special purpose acquisition company that has announced a deal in the past month has been rewarded with explosive share price growth:
- On June 5th, Collier Creek Holdings announced a deal with snack food company Utz Brands. On the news of the transaction, the shares went from trading around NAV to a 34% premium.
- On June 8th, Opes Acquisition announced a merger with fast casual restaurant chain BurgerFi. Its stock went from trading around NAV to a price that is 32% above its NAV.
- On June 12th, Forum Merger II announced a business combination with food company Tattooed Chef. The SPACs shares rallied from a -1% discount to NAV to a sizeable 44% premium on news of the deal.
A Good Bet
Clearly, we’re in a bull market for SPAC deals. However, many blank check companies are not yet pricing in this potential upside optionality.
The Accelerate Arbitrage Fund (TSX: ARB) is one of the few hedge funds that offer exposure to SPAC arbitrage. In addition, it is the only ETF that provides investors access to this strategy. While ARB holds nearly 30 SPACs in its portfolio, lately, we’ve been accumulating discounted SPACs of Q1 and Q2 2019 vintage, meaning those blank check companies issued in the first or second quarter of 2019. The reason behind this strategy is two-fold:
- SPACs trading at a discount to NAV offer a decent baseline arbitrage yield. This discount provides downside protection.
- SPACs issued 12-18 months ago are nearing their deadline to do a deal and therefore are most likely to announce a business combination in the near term. This dynamic offers the highest near-term upside optionality.
These discounted SPACs nearing the end of their life provide exceptional betting odds:
- Heads and the SPAC does not end up doing a deal, or does a transaction that the market hates, and an arbitrageur earns a yield of 1-2% to liquidation or redemption. We win.
- Tails and the SPAC does a deal that the market is keen on, and the share price rallies significantly above NAV, generating explosive stock price returns. We win big.
Personally, a “heads I win, tails I still win” bet is one that I can get behind.
-Julian
Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
