How to profit from the merger frenzy

By Tim Middleton

We're headed for a record year of acquisitions on Wall Street, and that's great news for investors in some low-risk mutual funds.

Those funds are known as merger funds. Their goal: Buy companies targeted for acquisition after the deals are announced, but get in at a price lower than the acquiring company will eventually pay.

That process, trimming the "spread," is so simple that fund manager Mario Gabelli named the portfolio he runs in this manner Gabelli ABC (GABCX). Does it work? Here's one bit of proof: "We've never had a down year," says Gabelli. This year the fund is up 7.6%, more then doubling the stock market's return.

Spreading the wealth

Though the closure rate on mergers is very high, it is not 100%. They can fail because the acquirer can't get financing or can't win approval from regulators or shareholders. So if a deal is announced with a price of, say, $20 for the target's shares, they trade for something less until the transaction actually closes.

Investors who buy before a merger are assuming some risk and want to be paid for doing so. How much they get paid is typically based on the current short-term interest rates. If short-term rates are higher than the deal spreads, the investor will just buy short-term bonds and bypass taking the deal risk. As short-term rates are relatively high right now, so too are the spreads.

"The risk-reward hasn't looked this good in quite some time," says Mike Shannon, a manager of Merger Fund (MERFX), the longest-established mutual fund specializing in this market. "The risks have stayed the same but the rewards have gotten better."

Since the stock market has grown riskier lately, investing in mergers looks increasingly attractive. Returns are modest -- since 1989, Merger Fund has delivered annualized returns of 8.5% -- but the risk of loss is low. The fund's standard deviation, or level of price volatility, is 5.32, which is 60% below that of Vanguard 500 Index (VFINX), a proxy for stocks in general.

A telltale that I watch closely also is favorable for this group. Merger Fund, the largest of these portfolios, recently reopened to new investors, having been closed in 2004 and 2005. Those were miserable years for the fund, when it delivered returns of 2.7% and 0.8%, respectively. As I've noted before, in general the worst time to buy a fund is just before it closes and the best is when it reopens.

Merge surge

Global mergers, which ebbed to $1.2 trillion in 2002, shot up to $2.75 trillion last year, and this year are running 38.9% ahead of last year's level, according to Thomson Financial. "We're very likely to see in excess of $3 trillion for the whole year," says Howard Horowitz, director of research for Water Island Capital, which runs the Arbitrage Fund (ARBFX). (Arbitrage is the technical name for spread skimming.)

That deal volume rivals the merger market's peak years of 1998 through 2000, and it is not concentrated in just one sector, as the Internet rage was. One surprising darling of the current merger mood is utilities, but acquisitions sweep across all industries, as well as around the globe.

The current enthusiasm for mergers is being fed by two factors. The first is a strong global economy, which encourages corporations to supercharge their growth through acquisitions.

The second is a global savings glut, which provides the necessary capital for buyouts and takeovers. Debt securities worldwide alone represent nearly $14 trillion. Blackstone Group recently raised $15.6 billion in a single mergers partnership. With leverage, it represents the potential for another $40 billion pouring into the marketplace.

Ordinary investors approach mergers and acquisitions through mutual funds. Just four of them compete in this niche. Two of those, Gabelli and AXA Enterprise Mergers & Acquisitions (EMAAX), are managed by Mario Gabelli.

The merger-fund marketplace

Fund	Manager tenure	Expense ratio	Performance, YTD	Performance, 1 year	Performance, 3 year
Gabelli ABC (GABCX)	13.2 years	1.14%	8.00%	10.30%	6.00%
AXA Enterprise Mergers & Acquisitions (EMAAX)	5.4 years	1.71	8.1	8.5	8.9
Merger Fund (MERFX)	17.5 years	1.77	7	5.7	4.9
Arbitrage Fund (ARBFX)	5.9 years	2.36	3.9	3.7	3.8

Note: As of 8/16/2006. Source: Morningstar

One of Gabelli ABC's holdings is Duquesne Light Holdings (DQE, news, msgs), an electric utility in Pittsburgh being bought for $20 a share by a unit of Australia's Macquarie Bank. After the deal was announced on July 5, Duquesne's share price jumped to $19.39. Gabelli bought shortly afterward, and expects to pocket the spread, about 60 cents, in next year's first quarter, for an annualized return on the position of roughly 10%.

Often while the price of the target company's stock is rising, that of the would-be acquirer is falling. Mergers can dilute the equity of existing shareholders of the acquiring company if the deal currency is stock rather than cash. Merger Fund regularly shorts the stock of the acquirer while owning the target, insulating it from changing conditions in the stock market.

For that reason, merger arbitrage is often called "market neutral," but that isn't precisely true. In bad markets for stocks, mergers can dry up, as they did from 2002 to 2003, leaving merger funds with little to invest in. That's why Gabelli is so fond of cash -- it's currently 44% of the ABC fund's assets. Cash at least delivers a Treasury bill return, which at the moment is nearly 5%.

Ahead of the merger game

Gabelli is also manager of the AXA fund, which is more daring than ABC. Whereas ABC and the other merger funds invest in publicly announced deals, the AXA fund invests up to a third of assets in stocks Gabelli believes may ultimately become takeover targets.

Last October, for example, he began buying shares in NorthWestern (NWEC, news, msgs) for less than $30 a share. In April, Babcock & Brown Infrastructure Group of Australia agreed to pay $37 a share for NorthWestern, which is an electric and gas utility in South Dakota. That deal is also set to close in next year's first quarter.

(Worth noting: Gabelli and companies he operates recently agreed to pay $130 million to the Justice Department to settle civil-fraud charges that he tried to deceive the Federal Communications Commissions in auctions of cell phone licenses, according to The Wall Street Journal. Gabelli denied any wrongdoing.)

Time to buy?

While Gabelli and Merger Fund compete head to head, Arbitrage Fund has been a laggard, hobbled in part by an extremely high expense ratio, which Morningstar calculates is 2.36%, or more than twice the ratio of Gabelli ABC.

Horowitz notes the fund's assets are small, about $172 million. Gabelli ABC is also very small, about $182 million, but Gabelli Funds manage many billions overall. Also, Gabelli makes it hard to buy his fund, limiting access to the firm's own customers and denying it to fund superstores. The minimum investment is also $10,000, recently down from $50,000.

The result is a steadier base of customers, which means lower overhead. Other merger funds are subject to drastic fund flows as their popularity waxes and wanes. Merger Fund closed because its assets had nearly doubled, to more than $1.6 billion, between 2002 and 2004. It reopened because, in 2005, they shrank to $1.26 billion.

Assets went up because returns heated up in those years. Outperformance to the upside, which is what leads to a fund's closing, is nearly always followed by the opposite experience, which is what leads it to reopen. Buying on closing is almost synonymous with buying at the top. Buying on reopening is smarter.

I happen to think the world's central banks, nearly all of which are raising interest rates, are going to wrestle the global economy into recession, which will be bad for mergers. When that will happen, however, is unknowable, and it's only a probability, not a certitude.

Meanwhile, mergers are afire, and the risks of taking advantage of this circumstance are low. If they continue at a high rate for at least one more year, you'll almost certainly do better than you could with cash.

Timothy Middleton is the author of "The Bond King: Investment Secrets of PIMCO's Bill Gross," and the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J. At the time of publication Middleton didn't own any securities mentioned in this article.