It looks like mergers will make a comeback in 2011, and there are a handful of mutual funds that focus on this Wall Street niche by profiting from the arbitrage on merger deals.
Last year, global mergers & acquisitions (M&A) activity spiked 22.9% to $2.4 trillion. The most active area was in the emerging markets. Going into 2011, it looks like the momentum will continue. U.S. companies are getting more confident as the economy improves. Oh, and aren’t they sitting on over $2 trillion in cash?
At the same, private equity firms — which also have huge amounts of cash — appear to be ready to ramp-up the dealmaking. According to a survey from Thomson Reuters, the forecast is that global M&A will hit $3 trillion this year.
How can investors benefit? Actually, there are a variety of M&A mutual funds, which focus on merger arbitrage strategies (also known as “merger arb”). This means that a portfolio manager will invest in pending acquisitions. In many cases, the target’s price will be below the offer — which will eventually rise as the deal progresses. This gap is due to the risk that the deal will fail to close, such as because of regulatory problems or financing issues. For example, this happened recently with Peabody Energy (NYSE: BTU) and its attempted deal for Macarthur Coal.
So let’s take a look at three merger arb funds:
Merger Fund (MERFX)
Founded in 1989, the Merger Fund (MUTF: MERFX) was the first in its category and has since invested in over 2,500 deals. The original manager, Frederick Green, is still at the helm. As is typical with a merger arb fund, it has demonstrated a steady track record. For example, the fund was up 3.3% over the past 10 years. This is actually a competitive performance since the S&P was essentially flat during this time.
But merger arb funds can go through periods when returns are nearly zero. Why? Simply put, this is occurs when deal activity shuts down. This happened from 2002 to 2003 as well as 2008 to 2009. During such times, merger arb funds are usually heavily in cash.
No doubt, the Merger Fund has strict policies. For example, it will not invest based on buyout rumors. The fund also uses hedging strategies and does not concentrate too much of the portfolio in a position.
With $4.1 billion in assets, the Merger Fund has an expense ratio of 1.41% and a turnover of 192.2%. Why the high turnover? The main reason is that merger transactions tend to be short-term.
Gabelli ABC (GABCX)
The Gabelli ABC Fund (MUTF: GABCX), which has $442 million in assets, has an expense ratio of 0.66% and turnover of 472%. Actually, since this high level of trading can increase your taxes, this fund may be best for an IRA.
The portfolio manager is Mario Gabelli, who is a long-term expert in M&A deals. One of his favorite areas is the media industry.
The Gabelli ABC fund is not strictly an arb fund, though. There are also investments in value stocks. Then again, these often make for attractive buyout opportunities, especially for private equity firms. In fact, the Gabelli ABC fund held up nicely in 2008, with a loss of only 2.63%.
AQR Diversified Arbitrage (ADANX)
Arbitrage is not only for investing in M&A. It is a general strategy to find profits when there are gaps in valuations between two types of investments. One is convertible arbitrage, which involves bonds that convert into a certain number of shares. Another is when-issued arbitrage – where new securities are issued because of a corporate spin-off.
As for AQR Diversified Arbitrage (MUTF: ADANX), it scouts for these diverse types of arbitrage opportunities. Of course, it is complex stuff. But like merger arb funds, the returns are stable.
But the AQR fund has a hefty 2.69% expense ratio and a turnover of 482%.