The Merger Fund Replaces the Arbitrage Fund in the Kiplinger 25
Arbitrage Fund has closed to new investors, but Merger Fund is a worthy replacement.
We decided to add Arbitrage Fund (symbol ARBFX) to the Kiplinger 25 in May 2010 (see Our 25 Favorite Funds) because we thought many investors might benefit from adding merger arbitrage to their portfolios. Merger arbitrage has historically been a good way to earn modest, bondlike returns with little volatility, and the strategy tends to hold up remarkably well in falling markets.
But after receiving an influx of new cash, Arbitrage Fund has closed its doors. The fund will continue to accept new money from existing customers. And new investors can still invest in the fund with certain discount brokers, including Vanguard, Scottrade and E*Trade.
We have found a worthy successor in Merger Fund (MERFX), which is open to new investors through discount brokers and directly through the fund company itself. Like its predecessor, Merger Fund invests in takeover subjects after an acquisition or merger has been announced. An acquiring firm usually pays a premium to a target company’s share price in a takeover. When a deal is announced, the takeover subject’s stock normally jumps, but not all the way to the purchase price. This gap, between the target company’s post-announcement share price and the deal price, represents the risk that the deal won’t be completed. Assuming there are no kinks in the deal, the spread will narrow gradually until it reaches the acquisition price upon consummation.
Merger Fund aims to capture the final few dollars -- or cents -- between the announcement and the deal’s completion. When investing in a transaction in which the buyer is using its shares for all or part of the cost, the fund will also sell short the acquirer’s shares to hedge against a slide in the acquirer’s share price. Co-managers Mike Shannon and Roy Behren also occasionally buy or sell options in order to hedge out any additional risks they feel might impact the takeover subject’s share price.
The result is fairly smooth performance that shows little connection to the overall market’s moves. Over the past five years through November 11, Merger Fund returned 4.8% annualized, compared with a 1.8% annualized gain for Standard & Poor’s 500-stock index, and it did so with less volatility than many bond funds. During the brutal 2007–2009 bear market, Merger Fund shed only 5.0%.
Why does the fund hold up so well in a rout? “Say you buy a target company’s stock at $19 per share, and it is the subject of a cash offer of $20 per share,” says Behren. “You’ll make that dollar whether the market goes up or down,” as long as the terms of the deal are met. “Our goal is to provide completely uncorrelated returns,” he says.
The greatest risk in running such a strategy is that a deal will fall through. About 90% of all announced mergers will in fact reach completion. But by investing selectively, Shannon and Behren achieve a success rate of about 98%.
Occasionally, a failed deal doesn’t equate to shareholder losses. For example, the pair recently had 6.5% of the fund’s assets in Potash Corp. of Saskatchewan (POT), the world’s largest producer of potash fertilizer and the subject of a hostile-takeover bid by BHP Billiton (BHP), a diversified commodities producer. Potash’s board of directors rejected the $130-per-share bid, which was announced in August, but its stock nonetheless jumped into the $140s on speculation that either BHP would increase its bid or that another suitor would step forward. Behren and Shannon say they believed the market was overestimating the likelihood that a deal would eventually close at a higher price, so they deftly used options to counter some of the investor euphoria surrounding the proposed deal. Thus, when the Canadian government announced on November 3 that it would block the acquisition, and Potash shares fell 2.4%, Merger Fund still held on to a few cents of gains on its Potash position. “I wouldn’t be surprised if we were some of the only arbitrageurs who made money there,” says Shannon.
Cross-border deals are increasingly making their way into the fund. The managers currently have about 30% of the fund’s assets in foreign stocks, compared with 10% to 15% ten years ago (the managers hedge all foreign-currency exposure). Looking abroad increases the total number of deals on their radar, which allows them to be choosier in deciding which specific deals to invest in.
But foreign deals can come with their own risks. For example, Coca-Cola Co. (KO) made a bid in 2008 to acquire Huiyuan Juice Group (CYUNF.PK), “the Tropicana of China,” says Behren. Any proposed acquisition typically must pass muster with antitrust regulators in the country of the target company, so Behren and Shannon hired local Chinese consultants to assess the likelihood that Beijing would approve the deal. At the time, Huiyuan itself claimed about 35% of the Chinese juice market -- a dominant but nowhere near monopolistic share of the market -- and Coke’s juice brands, which include Minute Maid and Odwalla, held no market share in China. In short, to an outside observer there wouldn’t appear to be much of a case for blocking the acquisition on antitrust grounds. But Shannon and Behren’s consultants advised them to avoid the deal, which Chinese regulators did end up blocking for murky reasons. As the pair explain it, China has yet to embrace the spirit of open markets that, for example, allowed U.S. regulators to tolerate InBev’s acquisition of Budweiser, no matter how hurtful it may have been to the pride of American beer drinkers.
Shannon and Behren are in the process of acquiring Merger Fund from the company owned primarily by Fred Green, the fund’s lead manager since 1989. However, Shannon and Behren have each worked on the fund for about 15 years, and have been gradually moving into the lead role since 2006. So investors are in good hands. The fund charges 1.44% in annual expenses and requires a minimum investment of $2,000 for both taxable and tax-deferred accounts.