Merger funds few, tricky
NEW YORK – If the reinvigorated market for mergers and acquisitions has put stars in your eyes, you may be pleased to know that a sliver of the mutual fund industry is devoted to making money off such deals. But you need to be aware that your choices among merger funds are limited.
Under the right circumstances, a merger fund can play a great supporting role in a diversified portfolio. Because their returns are driven by corporate activity, they are only weakly correlated to the stock and bond markets, so they’re unlikely to mimic the performance of your other holdings.
Rather than attempting to guess which companies might be ripe for acquisition – a strategy sometimes employed by value investors – most of these funds engage in merger arbitrage, meaning they seek profits from the successful completion of announced deals. In this strategy, one buys the shares of the target company and shorts the stock of the suitor. Assuming the deal gets done, there’s money to be made in the spreads.
Of course, some mergers present better opportunities for arbitrageurs than others; it’s not as simple as just snapping up shares the moment a deal is announced.
“We conduct lots of research before we make an initial investment,” said Roy Behren, chief compliance officer with the Merger Fund (MERFX), the oldest one on the market. “We look at the terms of the deal, the fit between the companies and the likelihood of the transaction occurring. The biggest causes of unsuccessful merger transactions are regulatory issues.”
Because of the nature of the strategy, turnover is high in merger funds, which means they tend to generate sizable short-term capital gains. For this reason, they are best suited for tax-deferred portfolios.
This kind of investing is not something experts recommend small investors try on their own. For the average investor, the transaction costs and tax implications can be “mind-boggling,” said Dan Culloton, an analyst with fund tracker Morningstar Inc. In addition to capital gains and trading costs, there are usually additional expenses related to shorting stocks.
“There are a lot of things to keep track of,” Culloton said. “If you’re not experienced or sophisticated enough, it’s best to seek this kind of investment through professional management. However, the options are few right now.”
In fact, there are just four merger funds on the retail market, and only two are open to new investors. The dearth of deals in recent years and competition from hedge funds has created a challenging market for merger arbitrage, and made it difficult for managers to put money to work. The Merger Fund closed last March, though a clone of the fund, the Merger Fund VL, is open to new investors through selected life insurance distributors. The relatively young Arbitrage Fund (ARBFX) shut its doors last year.
The two funds that remain open to new investors have significant cash stakes. The Gabelli ABC Fund (GABCX), one of the two merger funds open to new investment, holds more than 70 percent of its portfolio in cash. Manager Mario Gabelli has a long history in the merger arbitrage business, and the fund’s 0.65 percent expense ratio is low compared to similar funds. But the minimum investment of $50,000 makes it less than accessible for small investors, and the fact that it has held so much of its portfolio in cash for so long, even after reopening to new investors last year, helped make it a Morningstar “pan,” Culloton said.