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They're not a gold mine, but their volatility is low, and they seldom lose money
Anyone seeking green shoots in this economy should look at global M&A, where you can actually spot a few saplings. The value of deals in November hit $323 billion, the highest monthly tally since July 2008. Five deals valued at more than $10 billion, including Novartis' (NVS) bid for Alcon (ACL) this month, have been announced since December.
Dealmaking will be driven by cash-rich companies looking for bottom-line growth, rather than private equity firms, which still face a challenging financing environment, says Bob Filek, partner with PricewaterhouseCoopers Transaction Services in Chicago. These corporate hookups are the bread and butter of merger arbitrage mutual funds, which have seen total assets nearly double in size over the past year. "The driver of this wave of mergers is global growth, and it's happening now," says Mario Gabelli, CEO of GAMCO Investors in Rye, N.Y.
For all the seeming sexiness of dealmaking, Gabelli, who manages two merger arbitrage mutual funds, says the strategy is like "watching grass grow." It involves buying shares of target companies after a deal has been announced and profiting off the spread, or the difference between the target company's stock price and the price offered by the acquirer. The stock of the target will usually jump on news of the bid, but the risk that a deal might unravel leaves shares trading at a discount to the offer price—a discount usually equal to the interest rate on short-term Treasuries, plus a little more, to pay investors for taking a chance. Merger arbitrageurs buy after the announcement and wait for that discount to turn into a gain once the deal is complete. (If a deal is financed with stock, some managers short the acquirer's shares to lock in a spread.)
There are good arguments for investing in these types of funds now. Again, the thrill of the chase isn't one of them: Typically, these funds don't return much more than five percentage points or so above short-term Treasuries. Last year, most returned less than 10%, vs. the 26% gain for the Standard & Poor's 500-stock index. But losses are minimal: In 2008 few funds lost more than 3%. Because of such low volatility, and since these funds don't necessarily move with the stock market, "a lot of people use arbitrage strategies as a fixed-income replacement," says Morningstar (MORN) analyst Nadia Papagiannis. Since the life of an M&A deal doesn't usually run longer than four months, the funds have high turnover rates, meaning their stock holdings rotate in and out at a fast pace. "They're not very tax-efficient," says Papagiannis. She advises investors to buy these funds through tax-deferred accounts such as IRAs or 401(k) plans.
RISING RATES, RISING RETURNS
The 20-year-old, $2.3 billion Merger Fund (MERFX) has returned an average of 8% a year and lost money only twice. Co-manager Michael Shannon says rising interest rates expected over the next year or so will help boost returns. When capital costs rise, he explains, the spread gets wider because it is based on short-term rates.
The Gabelli ABC Fund (GABCX), which has had one losing year out of 15, is the cheapest of the funds. The annual cost to fundholders, expressed as a percentage of assets, is 0.64%. It is the only merger arb offering to get Morningstar's five-star rating. The four-star—and more costly, at 1.86%—Gabelli Enterprise Mergers & Acquisitions Fund (EMAAX) differs by investing in rumored as well as announced deals. Returns can be volatile: down 27% in 2008, up 25% in 2009.
The newest player: IQ ARB Merger Arbitrage Exchange-Traded Fund (MNA), launched in late 2009, with assets of $6 million. Index IQ CEO Adam Patti says its diminutive size is an advantage: "We can look at much smaller deals." At 0.75%, its costs are among the smallest, too.