Merger fund profits by investing in takeover stocks after the deal has been announced. It's also a good way to add diversification to your portfolio. By Andrew Tanzer, Senior Associate Editor May 21, 2007 These are busy times for investment bankers. Scarcely a day passes without news of some major listed corporation being acquired or taken private by a hedge fund or buyout firm. Can you invest in this merger mania? Yes you can, and in a surprisingly low-risk way that will add diversification to your portfolio.Merger fund (symbol MERFX), a recent addition to the Kiplinger 25, makes a living by investing in these deals by practicing something called risk arbitrage with deal stocks. Here, in a nutshell, is what it's all about. The three managers, Fred Green, Roy Behren and Mike Shannon purchase stock in companies involved in takeovers after the deals have been publicly announced. If Company A makes a bid to acquire Company B, Merger evaluates the deal and may purchase stock in B. This is because B will typically sell at roughly a 5% discount to the transaction price because of a risk the deal will fall through for regulatory or financing reasons. Or the terms of the deal may be renegotiated. At any one time, the Merger team is analyzing dozens of deals in the bubbling M&A market. For example, in the first quarter of this year the managers bought shares of TXU Corp., Dollar General Corp. and Triad Hospitals, and beefed up the fund's positions in Scottish Power and Clear Channel Communications. Because the managers exit positions when deals are concluded, annual fund turnover runs 300% to 400%, implying that stocks, on average, are held three to four months (more than 95% of deals are consummated). Advertisement You won't earn investment-bank-like fees for the deal-making, but what you net from Merger is a low-risk, low-volatility fund. Since its inception in 1989, the fund has had only one down year (2002, when it beat Standard & Poor's 500-stock index by a wide margin). Over the past year to May 21, Merger returned a respectable 11%. That's less than the stock market's gain, but a better way to view this fund is as a substitute for fixed-income money in your portfolio (over the past five years, the fund returned 5% annualized). Merger dances to its own tune, out of sync with bonds and stocks, and that will add some nice diversification to your assets.