Looking for a Unique ETF? This One Is More Valuable As a Warning.

When the first exchange-traded fund (ETF) was created, it was built to track the S&P 500 index. Following that success, Wall Street brought out more products that tracked other broad-based indexes.

However, the finance industry has a habit of pushing the limits, and an increasing array of highly focused ETFs were soon created. Many have done well, but not all of them have been good choices for investors.

A great example of that today might be AltShares Merger Arbitrage ETF (ARB -0.05%).

The purpose of an ETF

For most investors, using exchange-traded funds is a way to keep investing simple. In one trade you can get exposure to a large portfolio of investments for a fairly low cost. At first, as noted, ETFs were intended to track broad-based indexes such as the S&P 500. Pair that up with a bond ETF, and you have a simple, low-cost balanced portfolio that you can update once a year with just two trades.

For example, you could pair up Vanguard Total Stock Market ETF (VTI 0.77%) with Vanguard Total Bond Market ETF (BND 0.36%) and focus the rest of your time on enjoying life. You would, with just two trades, own the entire U.S. stock market and the entire U.S. bond market. Pick your mix, such as 60% stocks and 40% bonds, and head out to the door to the golf course or your child’s school play. After a year, and every year thereafter, bring the percentages back to your targets with two trades and you are done.

The cost? Vanguard Total Stock Market ETF has an expense ratio of 0.02% and Vanguard Total Bond Market ETF costs slightly more at 0.03%. On Wall Street, well, that’s practically free!

But some investors like to get a little more involved than that, and the finance industry is more than happy to oblige, for a fee. AltShares Merger Arbitrage ETF, for example, has an expense ratio of 0.77%. You would think that, for the cost, you should be getting something pretty special.

A unique approach but not a great option

To be fair to AltShares Merger Arbitrage ETF, merger arbitrage is not a simple investment approach. It requires tracking and analyzing companies that are going through acquisitions and mergers and investing around those deals in a way that produces consistent, though not spectacular profits. To simplify merger arb greatly, the goal is to collect the difference between the offer price of a deal and the actual price of the target stock which is usually slightly lower because of the risk that a deal could fall apart.

The hope is to have a lot of small wins while avoiding any big losses. The end result, if done well, is consistent performance in both good markets and bad markets. This is not easy to achieve.

ARB data by YCharts

While AltShares Merger Arbitrage ETF is fairly young, having only come public in mid-2020, it has dramatically trailed the performance of the S&P 500 index. While reinvesting the ETF’s distributions would have materially improved the performance, doubling the return from around 7% to 14% or so, the S&P had a price-only gain of 84%. Merger Arb is about reliably hitting singles, but so far it has fallen well short of an acceptable return for investors.

While the ETF’s performance hasn’t been as volatile as that of the S&P 500 (this is part of the allure of the merger arb approach), most investors will probably rightly balk at the laggard overall performance. Simply put, not all ETFs are great choices.

Too specialized an offering

At the end of the day, most investors will probably want to avoid AltShares Merger Arbitrage ETF and its lofty expense ratio. Unless you absolutely must own a merger arbitrage fund (and this isn’t the only choice you have), you’ll likely be happier elsewhere. Wall Street likes to go to extremes with complicated products, but most of the time investors should focus on keeping things as simple as possible.