BOSTON -- It can be scary to put your money in a mutual fund that uses an unusual investment strategy. Yet the prospect of solid returns can instill courage, particularly if there's a potential to profit no matter what the stock market throws at you.
Consider funds that trade stocks of companies about to be acquired, and try to exploit price differences between the time a deal is announced and when it closes. The two best-known offerings in this niche, the Arbitrage Fund and the Merger Fund, have rewarded investors with positive returns even while stocks have been mostly down since the market peaked in late 2007.
Arbitrage (ARBFX) has posted an average annualized return of 5 percent over the last 3 years, while Merger (MERFX) averaged 2.9 percent.
In that span, mid-cap growth funds, which invest in many of the same stocks as Arbitrage and Merger, lost an average 5.8 percent per year, according to Morningstar.
In addition to trouncing the category, the two funds avoided the broader market's sharp ups and downs. When the S&P 500 slid 37 percent in 2008, Arbitrage lost 1 percent, and Merger slipped 2 percent.
The protection means merger arb funds, as they're known among investing pros, could be a good option for a small piece of an investor's portfolio, probably no more than 5 percent. And these days, with companies holding plenty of cash, opportunities for the funds could expand if dealmaking comes back in fashion.
"They can be a good portfolio diversifier," says Nadia Papagiannis, a Morningstar analyst who covers alternative investing. "They'll provide downside protection, regardless of whether it's a good environment for the strategy."
The funds smooth out returns because they don't tend to move in step with stocks. Regardless of what the broader market does, the stock of a company that's about to be acquired generally rises if the deal stays on track after it's announced.
A buyer offers a premium to acquire the smaller company's shares. Once news of a deal surfaces, the targeted company's stock typically trades at a slightly lower price than what the acquirer is offering. This price gap is the merger arb investor's sweet spot. It's where money can be made, reflecting uncertainty whether a deal can be consummated.
Plenty can go wrong. Shareholders or regulators might not approve the transaction, financing might fall through, or a sudden turn in the market or economy might cause the acquirer to back out.
Merger arb fund managers assess pending deals for those mostly likely to close, and snap up shares of soon-to-be-acquired companies that appear to be cheaply priced.
The chances of walking away with a profit after a deal closes improve the more pending transactions there are to choose from, and the fewer rival investors there are bidding up stock prices. Merger arb fund managers compete against hedge funds, where the strategy is more common.
Lately, opportunities have been mixed. Many hedge funds went under or scaled back their use of the strategy during the financial crisis. So the field is less crowded.
At the same time, there have been fewer deals lately, due to the struggling economy. With $488 billion worth of deals so far this year, U.S. mergers and acquisitions are down about 1 percent from the same point a year ago, according to M&A tracker Dealogic. "We're still far from the boom years" before the recession, says Todd Rosenbluth, a Standard & Poor's fund analyst.
Yet the pace of deals and opportunities for merger arb funds could pick up sharply if the recently stalled economic recovery regains momentum.
That's because many companies are sitting on cash hoards built up during the recession. S&P 500 companies had $3.2 trillion in cash and short-term investments at the end of the first quarter, up nearly 40 percent from three years ago, according to the research firm Capital IQ.
Once confidence returns, expect those big companies to dip into cash and make deals for smaller companies at a faster clip. A recent S&P report says cash-rich U.S. companies such as drug maker Pfizer Inc. and computer chip maker Intel Corp. are in good position now to do deals, particularly acquisitions of European companies whose stocks are cheap amid that continent's debt crisis.
On Thursday, Intel announced a domestic purchase, saying it is buying California-based computer-security software maker McAfee Inc. for $7.68 billion.
Even though M&A remains subdued, there's plenty of opportunity. Amid recent strong performance, the decade-old Arbitrage fund has swelled to $1.5 billion, about triple the figure a year ago. With all the money flowing in, the fund closed to most new investors last month.
The $3.3 billion Merger fund recently told shareholders it had 61 arbitrage investments, a near-record since its 1989 launch. Since then, the fund has had just two down years, and returned more than 7 percent a year, on average.
One of the fund's recent winning deals: Hewlett-Packard Co.'s $2.7 billion takeover of computer-networking equipment maker 3Com Corp., which ratchets up HP's rivalry with Cisco Systems Inc.
Three other funds that are less well-known than Merger and Arbitrage also heavily rely on merger arb strategies: Gabelli ABC (GABCX), Quaker Event Arbitrage (QEAAX) and AQR Diversified Arbitrage (ADANX).
Despite merger arb funds' generally strong long-term records, investors will want to consider at least two things before getting in:
--Tax hit: These funds are trade-happy, moving in and out of stocks as deals are announced and closed. The behavior is more likely to trigger taxable capital gains than buy-and-hold investing. It's not unusual for merger arb funds to trade so frequently that their portfolio turns over three or four times a year. Most mutual funds turn over less than once a year.
The potential tax bite from all that trading means these funds are best held in tax-deferred retirement accounts, like IRAs or 401(k)s, rather than taxable accounts.
--Market risks: In down markets, merger arb funds can still get hit, even though they emerged mostly unscathed in 2008. Pending acquisitions often fall apart or are renegotiated if a credit crunch hits and financing dries up, which can stick merger arb funds with losses. And while they can still serve as a buffer when stocks are falling, the funds tend to lag when stocks sharply rebound.
"You won't be getting as much of the upside," Rosenbluth says. "But you will be protecting more of your downside when the rally is over."