M&A Funds: Sexy and Steady? The steady increase in M&A activity has many investors wondering how to take advantage of Wall Street’s deal making

SATURDAY, FEBRUARY 8, 2014

M&A Funds: Sexy and Steady

By AVI SALZMAN | MORE ARTICLES BY AUTHOR

The steady increase in M&A activity has many investors wondering how to take advantage of Wall Street’s deal making. These two funds do it well—but don’t be fooled by the wrapper. These are essentially income funds.

Arbitrage has a risky—even sexy—reputation. In the 2012 film Arbitrage, hedge-fund magnate Richard Gere seduces a mistress, flies on a private jet, and defrauds investors, all in a day’s work.

Retail investors can also engage in arbitrage, an investment strategy that exploits asset-price differences. An upswing in mergers and acquisitions has created more opportunities to profit. The value of global M&A deals rose 9% in 2013, and analysts expect another high-volume year in 2014. The $277 billion worth of deals signed so far this year is 46% above 2012 levels, according to Dealogic.

Since there’s no Merger Arbitrage for Dummies book out (yet), most investors are better off exploiting this trend via a mutual fund. The Merger Fund (MERFX) and theArbitrage Fund (ARBFX), managed by separate companies, both use an arbitrage strategy that provides Steady-Eddie returns.

These real-life arbitrageurs display little of Gere’s joie de vivre. “Arbitrageurs have a reputation as cowboys, but it’s actually a fairly conservative strategy,” says Roy Behren, co-portfolio manager of the Merger Fund.

In fact, they seem to spend most of their time worrying. It keeps them up nights: Both funds employ people who watch global markets at all hours, some of whom stay up until dawn. “All we do is think about what could go wrong,” says Jonathan Schonberg, a director at Water Island Capital, which manages the Arbitrage Fund. “We’ll screen 40 different risk factors on a deal.”

Both funds play M&A deals by buying the acquired company after the deal is announced and—if the deal involves a stock transaction—shorting the acquirer. If they’re doing their jobs right, they’ll earn the spread between the stock’s price after the deal announcement and the eventual closing price. The biggest risk is that the deal will fall through, causing the stock of the target company to plummet. Their portfolios turn over fast, and a few botched deals can erase an entire year’s gains. The more M&A activity, the choosier these funds can be.

WHILE FOCUSING ON THE HIGH-WIRE world of arbitrage, these funds trade more like bond funds. The Merger and Arbitrage funds have gained an average of 3.4% and 2.8%, respectively, annually over the past 10 years—well below the Standard & Poor’s 500’s average annual gain of 6.7%.

The S&P has swung wildly during that period, with a 37% drop in 2008 and a 32% gain in 2013, but the M&A funds have registered steady gains. Behren estimates the Merger Fund is about one-fifth as volatile as the S&P 500. Since 2004, it has registered one loss, a 2.3% drop in 2008, while its largest gain was 11% in 2006. In 2013, the Merger Fund rose 3.6% and the Arbitrage Fund, 0.9%. A few scrapped deals, including United Parcel Service‘s (UPS) aborted bid to buy TNT Express (TNTE.Netherlands), hurt the Arbitrage Fund’s performance.

What makes the funds particularly attractive, however, is that unlike most bond funds, they benefit from rising interest rates. Higher rates tend to widen the spread between the post-announcement stock price and the deal-closing price, leaving the arbitrageur more room to profit. With bonds showing more volatility in the past year, and higher interest rates ahead, the funds offer an alternative to bond products—a sort of hedge on your hedge. A pickup in M&A would give the funds more targets, with more potential upside.

Plus, you get to tell your friends you’re into arbitrage.