An event-driven investment strategy can help investors to capitalise on events that might cause pricing inefficiencies in the market. This article will provide an overview of event-driven investing, some of the main strategies, and how to understand the risks involved.
An event-driven investment strategy offers investors the opportunity to capitalise on events that might cause sudden or sharp price changes in the market.
This type of strategy is commonly used by hedge funds and private equity, in transformative scenarios such as acquisitions, mergers, takeovers or bankruptcy.
An event-driven investment strategy utilises the misalignment of a stock price during a business’s transitionary period or market-moving event.
Retail investors may also analyse “market-moving events” to make predictions about future price movements. For example, considering trading airline stocks during the COVID-19 pandemic, when global travel bans were common.
What is an event-driven investment strategy?
All event-driven investment strategies aim to take advantage of short-term market mispricing, caused by an event.
Investors who adopt this strategy might follow the expertise of analysts, skilled enough to determine how various actions will impact the market.
Analysts will consider the current environment, any likely synergies and the possible outcome of any merger, acquisition or other significant event. A decision will then be made regarding the best way to invest, based on the current stock value relative to the predicted value before or after the event takes place.
These events may include acquisitions, mergers, takeovers, bankruptcy, or any other transformative scenarios
When the analysis is correct, the investor stands to make a return. However, if the calculation is incorrect, they could end up losing money.
A specialist in event-driven investing will focus on analysing the likely impact of an event on stock prices, rather than the more traditional approach of studying and researching company earnings or dividends.
Tip: You can conduct a thorough analysis of stocks during transitional periods, by tracking price movements over time.
Event-driven strategies
Event-driven strategies are usually implemented through equities or credit securities, such as bonds. However, different types of techniques can be applied in event-driven analysis.
Risk arbitrage
An event-driven investor utilising risk arbitrage will look for catalysts of change (such as earnings reports, new products or legislative changes) that may impact price movement.
This is one of the most widely used event-driven analysis strategies.
Merger arbitrage
Investors using merger arbitrage focus exclusively on merging companies.
Generally, the aim of an acquisition or merger is to increase a company’s value. If an investor correctly times a trade, they can buy-in before the market has reacted to the potential success of a merger, and see returns as the price subsequently rises over time.
The risk here is if the market actually devalues the stock in the event of the merger, or if the deal fails.
Capital structure arbitrage
Capital structure arbitrage involves buying different types of securities from the same issuer. Investors buy undervalued stock and sell the overvalued, until the market manages to restore the imbalance in pricing.
For example, bonds tend to react more slowly to corporate news, so by buying stocks and bonds from the same company and trading carefully, investors may be able to make money while the market corrects itself.
Tip: Arbitrage investing is typically regarded as being very high risk, and more suitable for experienced investors
Holding and subsidiary companies
Generally, a holding company does not actually produce anything, it simply holds the assets (wholly or partially) of various subsidiaries and has oversight of business practices.
It is possible to calculate the net asset value of the holding company, and the value at which the holding company shares are traded. There may be a variance between these values, and, thus, a revaluation will be due.
An event-driven investor may capitalise on this change, either by identifying an event that will change this variation, or by taking stock at the existing discount.
Distressed debt investing
This is the process of investing in the existing debt of a financially distressed company, government, or public entity.
The investor seeks out stocks that are undervalued by the market, in order to receive the returns that will be issued to stakeholders following a sale, takeover or company liquidation.
Tip: Investors may also see returns if the stock becomes favourable in the market again, so this is typically considered a lower risk strategy.
Merger or risk arbitrage are the most common forms of event-driven trading. Consider a practical example of how risk arbitrage works:
- Company A is subject to a cash takeover at $50 per share. The deal is subject to several conditions, including shareholder approval and regulatory clearance.
- Before this event was announced, the share price was $30.
- Post announcement, the company’s shares trade at $40, as the market is not entirely convinced it will complete as planned.
- Current shareholders may not want to hold on until the deal completes, as they are already up $10 a share, and may potentially lose this return in the event that the deal fails.
- However, an event-driven investment strategist will see this scenario differently. By purchasing shares at $40, the investor stands to make an attractive return should the deal complete as planned.
Market-moving events
In a corporate capacity, market-moving events refer to anything that brings organisational change and impacts stakeholders or shareholders. Although a board of directors usually agrees about events such as mergers and acquisitions, in some cases, shareholders will be invited (or required) to vote on the event.
Any corporate action within a publicly traded company will initiate a process that will affect its share price. This could be a mandatory action, as big as forced liquidation or bankruptcy, or a decision such as a name change.
Tip: Mergers, acquisitions and stock splits are all examples of corporate actions.
Outside of specific corporate actions, there are many other market-moving events that can cause price fluctuations by influencing the behaviour of investors, such as:
- Natural disasters or extreme environmental events
- Technological advances
- Political instability
- Global conflict
- Government regulation, fiscal and monetary policies
Market-moving events can come in many forms, but will all provoke some type of reaction from investors, whether to buy, sell or retain investments.
Depending on the nature and seriousness of an event, the market may even experience a serious and long-term crash or boom. Historically, there have been many significant events that have heavily impacted the financial markets, ranging from global crises to isolated market- or asset-specific events, such as the 1973 oil crisis or the 9/11 terrorist attacks.
Tip: Such events can cause short- and longer-term effects on the economy and global politics.
The 1973 oil crisis
The Organisation of Arab Petroleum Export Countries (OPEC) members triggered the first major oil crisis in October 1973. OPEC announced an embargo on countries that had supported Israel during the Arab-Israeli conflict, which affected countries including the USA, the UK, Japan and the Netherlands.
The price of oil increased by 300% in the US in the course of a year, and various western banks cut interest rates in an attempt to encourage growth.
The 9/11 terrorist attacks
The events of 9/11 led to a sharp stock market plunge. The US market was hit with a $1.4 trillion loss in value, as markets and brokers struggled to function.
To prevent panic selling, the NASDAQ and NYSE closed until September 17th. However, when the market reopened, it lost value rapidly. The S&P 500 and NASDAQ losses were 11.6% and 16% in a week, respectively.
Two of the most affected industries were insurance and airlines. Although there were many repercussions of the terrorist attacks, one of the major consequences was the war in Afghanistan, which continued for 20 years and cost trillions of dollars in taxpayers’ money.
Risks of event-driven investing
Event-driven investing can be a profitable strategy. However, due to market volatility, rapid price movements and the complexity of market dynamics, it is not without risks.
Any event-driven investor must accept that corporate events may not play out as expected. Unexpected changes can cause an event-driven prediction to fail at any stage, for any number of reasons.
Recognising when liquidity levels are lower, volatility is higher and algorithms are more prevalent, for example, can help investors to better understand these market conditions. This is why conducting a full analysis of market conditions is always an important way to mitigate the risks involved in event-driven investing.
Any investor should be risk aware and have processes in place to manage and monitor the events they have invested in, in order to react appropriately.
Final thoughts
Event-driven investing is a strategy to leverage the price fluctuations associated with a market-moving event to seek potential returns. Always seek advice from a specialist in event-driven investment strategies to make educated investment decisions.
Learn more about investing on the eToro Academy.
FAQs
- What is event-driven investing?
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An event-driven investment strategy is a tactic used by investors to profit from market-moving events that can cause pricing inefficiencies in the stock market.
- What is a market-moving event?
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A market-moving event is any event that will bring changes to a company. This could be a large change such as a merger or acquisition, or a less quantitative event such as a company name change or product launch. It could also be a political or other world-impacting event.
- What are the risks of an event-driven strategy?
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While event-driven strategies can lead to profitable results, factors such as volatility in the market, rapid price movements and the complexity of specific market movements do create risk.
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eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.