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4 funds that get you in the merger game
Comcast wants Walt Disney. Oracle is still going after PeopleSoft. There's money to be made in these deals, and some funds offer low-risk ways to take advantage of that.
By Timothy Middleton
As stocks recover, so do mergers and acquisitions. From Walt Disney (DIS, news, msgs) to PeopleSoft (PSFT, news, msgs), tempting takeover targets are emerging, and mutual fund investors can play this game through any of several portfolios that specialize in it.
But before you play Gordon Gekko, know this: If takeovers are one of the stock markets express trains, at times boosting stocks by double-digit percentage gains, merger funds are milk trains, stopping at every station and proudly delivering fat-free returns in the high single digits, or slightly better.
Their goal is to shoot for steady absolute returns in the range of 9% to 15% year in and year out, and they try to do that with very low volatility, says Dan Culloton, an analyst with fund-tracker Morningstar. The funds act as arbitrageurs, seeking to skim a portion of the takeover premium while shunning as much risk as they can.
How it works
Here's how deal arbitrage works. When takeovers are announced, the share price of the target usually spurts toward, but not quite to, the acquisition price because some uncertainty remains about whether the deal will close. Arbitrageurs, or arbs, step in to capture a share of the premium. For instance, if the offer is $35 a share and the target stock trades at $33, arbs buy and wait to get that $2 per share premium.
Meanwhile, the stock of the buyer often falls, as investors fret about things like how much it's paying and whether it'll be able to integrate the acquisition well. So arbs sell short the buyer's stock, betting it will fall, as a way to neutralize their risk.
In Disneys case, however, its stock price already has exceeded Comcasts (CMCSA, news, msgs) hostile offer, meaning this one is fraught with risk. So, many arbs are avoiding it. If Brian Roberts at Comcast thought he could buy Disney on the cheap because the board is tired of (CEO Michael) Eisner, that may be a big miscalculation, says one arbitrageur at a private money management firm, who insisted on anonymity.
More likely to find its way into a merger arbs hands are deals where risks are low. When its fiscal year closed in September, Merger Fund (MERFX) had a big stake in French aluminum maker Pechiney, then in a deal to be acquired by Canadas Alcan (AL, news, msgs), another aluminum company.
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So a merger fund -- and there are three others besides Merger Fund -- actually exploits the stock market to deliver near-market returns with considerably less risk. Arbitrage Fund (ARBFX) has delivered annualized returns of 9.8% since it began late in 2000, with about 24% less price volatility than Vanguard 500 Index Fund (VFINX).
The newest entrant into this tiny category is Enterprise Mergers & Acquisitions Fund (EMAAX), which is managed by the famed value investor Mario Gabelli and will be 3 years old this month. Gabelli uses arbitrage, like his rivals, but he also invests in potential takeover targets. For instance, one of Gabellis largest holdings, Cablevision Systems (CVC, news, msgs), is considered by many to be a target as the media industry consolidates.
Betting on a sure thing
Gabelli also runs a merger fund in his own name, Gabelli ABC Fund (GABCX). It differs from the Enterprise fund in that it invests strictly in announced deals. Gabelli ABC had been closed but the firm announced last week it was reopening. As Ive often observed in the past, the reopening of a fund often signals that its investment markets have been cool but are warming.
Like Gabelli with his ABC Fund, Fred Green and Bonnie Smith of Merger Fund dont speculate. The announced goal of their fund, which was launched in 1989, is to invest strictly in announced deals with a high probability of success.
Usually, that means friendly deals, but there are other hurdles, as well. Some deals get hung up on antitrust or other grounds. Merger arbs typically dont leap into a stock moments after a deal is announced; they instead begin to study the companies, and the particulars of the deal, to satisfy themselves it will go through.
Merger Funds annualized returns since inception have been 9.1%. The funds 10-year standard deviation, a measure of price volatility, is 5.16, or less than one-third of the markets 17.62 fluctuation over that period. That means the funds net asset value tends to rise or fall much less than the market, typically in the mid-single digits, compared with the markets double-digit volatility.
Real returns
These funds seek absolute rather than relative returns, which is something of a foreign notion for most investors. The typical equity fund compares itself with the Standard & Poor's 500 ($INX) or some other benchmark; if the market is down 20% but the fund is only down 10%, its managers are pleased with themselves.
But especially after three years of bear market, many investors now prefer a fund that seeks to deliver positive returns no matter the financial climate. All of the merger funds resisted the bear market to one degree or another
| Merger fund performance | | Fund | 2000 rtn. (%) | 2001 rtn. (%) | 2002 rtn. (%) | 2003 rtn. (%) | | Merger | 17.6 | 2.0 | - 5.7 | 11.0 | | Arbitrage | n/a | 8.7 | 9.3 | 15.2 | | Enterprise | n/a | n/a | - 3.3 | 15.5 | | Gabelli ABC | 10.7 | 4.6 | 0.9 | 4.9 | | Vanguard 500 Index | - 9.1 | - 12.0 | - 22.2 | 28.5 |
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Note: n/aNot applicable
Source: Morningstar
Because of their design, Morningstar puts these funds into its conservative allocation category, which consists primarily of funds that are more than 50% bonds. Equity investors can use them to reduce the volatility of their portfolio, as bonds do, without significant interest-rate risk.
Fixed-income investors can likewise use them to mute volatility, as well as to add some near-equity performance.
Not quite neutral
Although the funds view themselves as market-neutral, theyre not. When the merger window is closed, as it was in the bear market, their returns can be disappointing and even disappear. Merger Fund had its first negative year in its history in 2002, amid the worst of the bear market in stocks.
So the funds are hardly risk-free. But given a strengthening economy, their prospects are good. Merger activity is rebounding and with it the opportunity to skim a few dollars from each of a growing number of deals.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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