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M&A, Currency-Hedging ETFs to Consider in a Rising Rate Landscape

This article was originally published on ETFTrends.com.

Last week's market sell-off that saw the Dow Jones Industrial Average lose over 1,300 points in two consecutive trading sessions caused investors to flee towards floating-rate bond ETFs and Treasury Inflation-Protected Securities (TIPS) as they dumped U.S. equities in the face of rising yields. However, other options to consider include exchange-traded funds that can dull the effects of rising rates, such as the IQ Merger Arbitrage ETF (MNA) and the IQ 50 Percent Hedged FTSE Intl ETF (HFXI) .

Mergers and acquisitions have been abound in various sectors as the historic bull market seen as of late in U.S. equities has been helped by a rise in such activity, particularly from the technology sector that has been fueling much of the growth this year. Notable activity came from the likes of tech giants, such as Hewlett-Packard Enterprise, Cisco Systems, Accenture, Cisco Systems, AT&T, and Sprint.

However, mergers and acquisitions have been seen across a variety of sectors, which has helped MNA. MNA seeks investment results that correspond generally to the price and yield performance of its underlying index, the IQ Merger Arbitrage Index, which seeks to employ a systematic investment process designed to identify opportunities in companies whose equity securities trade in developed markets, including the U.S., and which are involved in announced mergers, acquisitions and other buyout-related transactions.

"We have seen strength in M&A across the board, with some rotation among sectors, as the year has gone along.  In the first half alone, a record $2.5 trillion in deals were announced worldwide, including more than $1 trillion in the US alone," Salvatore Bruno, Chief Investment Officer of IndexIQ, told ETF Trends.  "Healthcare was active, with 255 deals in the second quarter, the 15th consecutive quarter with more than 200 announced deals, according to PricewaterhouseCoopers (PwC). Globally, the energy & power sector has seen a lot of transactions.  The Media industry has seen some major activity, with $323 billon in deals announced through the first half of the year.  Over the same period, technology transactions were up more than 50% from 2017, to nearly $208 billion.  Almost every sector saw growth, with the one standout exception being Consumer Products and Services."

Related: Director of IndexIQ Research Discusses Fixed Income Innovations

An acquisition may require creative financing on the part of the acquiring company, and this may include using loans as a capital resource. However, the Federal Reserve just installed its third rate hike last month, raising the federal funds rate another 25 basis points to its current level of 2.25.

However, mergers and acquisitions have turned more to stock-based financing to nullify the increased costs of borrowing money in a rising rate landscape.

"The cost of money is certainly a consideration in M&A, particularly for highly leveraged deals," said Bruno. "Our hedge ratios have seen an increase, which indicates more stock-based financing, but at this point, however, there is a substantial amount of cash still available to both financial and strategic buyers.  Private equity firms have raised tens of billions of dollars in new funds over the past several years that they need to put to work. Similarly, corporations have billions of dollars of cash on the books. Economic growth – and a robust stock market – remain supportive and are important factors."

Currency Hedging Against a Rising Tide of Rates, U.S. Dollar

The rise of rates and the U.S. dollar have presented challenges abroad, particularly in the emerging markets sector. That has only been exacerbated by the latest trade wars, particularly the tariff-for-tariff tennis match between the United States and China.

However, currency hedging via developed markets through an ETF like HFXI has allowed investors to lessen the effects of rising rates and a strengthening greenback as opposed to their less-developed peers in emerging markets. HFXI seeks investment results that correspond generally to the price and yield performance of its underlying index, the FTSE Developed ex North America 50% Hedged to USD Index, which is an equity benchmark of international stocks from developed markets, with approximately half of the currency exposure of the securities included in the underlying index "hedged" against the U.S. dollar on a monthly basis.

"A stronger dollar tends to attract capital to the US, but the developed countries are in a much better position than most emerging markets when it comes to competing for financial resources," Bruno said. "European capital markets are deep and well established and can provide access to funds priced in Euros.  Because many goods are priced in dollars, these countries may actually become more competitive as the dollar strengthens.

"In terms of interest rates, the US Federal Reserve is ahead of most of the developed world in the tightening cycle so that the reaction of markets here may provide some insight into what we can expect in Europe.  It seems likely that rising rates will cause some dislocation there as well, but how significant that will be will depend on a number of factors including overall economic growth and the pace of tightening."

According to Bruno, HFXI uses a 50% currency hedge that is able to absorb any volatility seen in the U.S. dollar. This strategy allows HFXI investors to obtain exposure to international markets with the diversification of various local currencies as opposed to simply one currency to help decrease risk.

"We call this the 'hedge of least regret,'" said Bruno. "It helps smooth out returns, providing support for investors to maintain exposure to global markets as part of an overall portfolio diversification strategy, without taking a directional bet on any single currency.  The hedging process itself is agnostic when it comes to sectors; rather, it is applied at the portfolio level.  HFXI recently had exposure to 23 countries and 14 different currencies, all hedged approximately 50% to the US dollar."

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