How do arb funds construct and manage a diversified merger arb portfolio?

How to answer

Portfolio construction involves: (1) sizing positions based on expected return, deal risk, and liquidity (typically 2-5% per deal); (2) diversifying across 20-50+ deals to reduce idiosyncratic deal break risk; (3) limiting sector concentration to avoid correlated regulatory risks; (4) managing gross and net exposure targets; and (5) reserving capital for new deal flow. Risk management includes stop-losses (or dynamic re-underwriting if spreads widen), stress-testing for multiple simultaneous deal breaks, monitoring portfolio beta, and tracking timeline drift. The portfolio should be self-hedging: if credit markets deteriorate, new deal spreads widen, providing reinvestment opportunities.

Key idea: 20-50+ deals, 2-5% position sizes, diversified by sector and deal type.