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Posted 1/22/2002
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A low-risk, big-reward way to diversify Newly reopened Merger Fund offers the returns of a stock with the safety of a bond. Here's how it turns takeovers into profits. By Timothy Middleton During the great bear market of 2000-01, equity investors got a taste of risk straight up. It was the first time in a generation that major market indices finished in red ink for two consecutive years.
But one fund managed to avoid the carnage; indeed, it’s never had a down year in its 13-year history. What is more, Merger Fund (MERFX) is also the safest equity mutual fund in the industry, with a 10-year standard deviation of only 4.6%. Vanguard 500 Index (VFINX), by contrast, has a deviation of 16.4%. (Standard deviation measures the range of a fund's performance. The higher the number, the greater the volatility.) Merger Fund manages to do so well because what it does is so different. It captures small premiums in corporate takeovers. There is no market index that tracks such things, so the fund has nothing to compare itself with except its own modest goals. “It shoots for absolute returns, regardless of where the market goes,” says Dan Culloton, a Morningstar analyst. “Only twice in the last seven years has it failed to achieve the 10% to 15% gains that it wants, and even in those years it went up.” If you had foreseen the market’s meltdown in 1999 and wanted to shift capital into Merger Fund, you couldn’t have: The fund was closed to new investors. But late last year, when the stock market began to rally, it suffered redemptions, and has reopened. I’ve noted before that one of the best times to buy a fund can be after such a reopening. If Merger’s strategy fits into your portfolio -- or if you’re so scared of equities now that you don’t want a conventional fund -- this is a good time to check it out. How it profits Merger’s managers, Fred Green and Bonnie Smith, are arbitrageurs. They take advantage of the everyday fact that, when a corporate acquisition is announced, the target company’s stock doesn’t rise all the way to the deal’s price at once. Deals can take months to close, and they can unravel. Those risks are reflected in the target company’s share price, and Merger Fund deals only in those risks. When a corporate merger is announced -- Merger Fund doesn’t invest in rumors, only publicly disclosed acquisitions -- Green and Smith begin researching both sides of the transaction. “Some deals have a lot of moving parts, so to speak,” Green says. “The (target company’s) industry may be a factor. How tight is (the deal) written? What is the antitrust outlook?” The fund typically holds positions in about 40 pending deals, to achieve broad diversification across sectors and to minimize the risk of any one deal going south. The average takeover slogs along for three months to four months. Merger Fund might get involved the day a deal is announced, if it already knows a good deal about the players, but usually it takes time to research. One pending acquisition in which Merger Fund has taken a stake is the takeover of C.R. Bard (BCR, news, msgs), a maker of medical devices being acquired by Tyco International (TYC, news, msgs). Originally set to close Jan. 31 but recently postponed to March 31, the deal would pay 1.128 shares of Tyco for every share of Bard. At their respective prices early in January, that would value the deal at about $62 for each Bard share. With Bard recently trading for around $60.20, the arbitrage spread Merger Fund expects to capture is $1.80. Meanwhile the fund has sold short enough shares of Tyco to cover, or hedge, the deal. When the acquisition is completed, it will use the shares of Tyco it acquires to cover the short position. Merger Fund is able to hedge many of its bets this way. In all-cash deals, Merger Fund doesn’t short. (Tyco shares have been pummeled in recent weeks amid rumors its acquisition binge -- more than $50 billion in five years -- is the subject of an SEC investigation. Tyco has denied it is being investigated.) Risks Historically, the fund has delivered on its promises. Over the three years ended Dec. 31, its annualized returns were 12.1%. Over the last 10 years, they were 10.7%. But while Merger Fund avoids stock-market risk, it is vulnerable on two scores. Deals can blow up, and the merger market can dry up. Both things happened in 2001, and the fund delivered its worst performance in a decade, rising only 2%. “In dollar terms, the merger and acquisition market was off 50% last year; that’s a pretty pronounced slump,” Green says. Also last year, the fund was sideswiped when General Electric's (GE, news, msgs) takeover of Honeywell International (HON, news, msgs) was scotched by European regulators. (Tyco, meanwhile, is so active in the takeover market that, earlier this month, its share price fell nearly 10% on rumors, since denied, that it was going to bid for Honeywell.) With the fund’s returns ebbing, and the stock market catching fire late in the year, Merger Fund suffered “some redemptions,” Green acknowledges. So in October it was reopened, having closed in the summer of 1998. Assets currently are nearly $1 billion, and in early September, cash reserves had ballooned to $300 million because so few deals were attractively priced. The events of Sept. 11 hammered stocks so hard, however, that arbitrage premiums soared and Merger Fund became fully invested within a week or two. Closed funds usually reopen because they’ve gone soft, just as they closed in the first place because they were so hot. But even as closing often precedes underperformance, as happened last year at Merger, reopening often precedes outperformance. This happened most recently with Vanguard Health Care (VGHCX). After the fund shot up 40.8% in 1998, assets ballooned and it was closed. In 1999 its return tumbled to a gain of only 7%, assets fled, and it reopened at the end of the year. The next year it surged 60.6%. A great way to diversify No such eye-popping surge can be expected from Merger Fund, however; just as ignoring stock risk is a boon in a bear market, it’s a drag when the bull comes back. Rather, Green forecasts a return to the fund’s usual pace this year of delivering gains in the low double digits. “I think merger activity will show signs of recovery in the next six months, assuming financial markets stabilize,” he says. “We don’t need a new bull market, but we do need markets to stabilize and the economic outlook to become a little clearer.” In addition to its limited upside, the fund has other attributes that reduce its appeal for some investors. It holds onto positions for only a few weeks or months, so turnover is high. Most of its returns are short-term capital gains, so its tax efficiency is poor (about 70% over the last five years, compared with 94% for Vanguard 500 Index). But it will appeal to people who are serious about diversifying their portfolios, because Merger Fund’s performance doesn’t correlate with other financial assets. Its beta, relative to the S&P 500, is a minuscule .06. (By definition, the beta of Vanguard 500 Index is 1; the lower a beta, the less a fund’s performance is affected by movements of the broad market.) The asset class with which its returns most closely correlate is high-yield bonds, and their beta is only .22. But high-yield bonds are much riskier than Merger Fund, with a 10-year standard deviation of 7.6%. Especially in IRAs, 401(k)s and other tax-deferred accounts, where its poor tax efficiency doesn’t hurt, Merger Fund is possibly the best diversifier any investor, equity or fixed-income, could find. It has about the same risk as intermediate-term bonds, but delivers returns 50% greater. At the time of publication, Timothy Middleton didn’t own any of the securities mentioned in this article. 
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