Merger Arbitrage (also called risk arbitrage, merger arb, or risk arb) is a strategy that is popular among hedge funds and some specialty mutual funds. When a public company gets acquired, the acquiring company typically pays a premium and the closing does not typically happen for several months. This time period between merger announcement and merger closing is the time period when a merger arbitrage investor would consider holding the stock.
The Typical Merger Deal
Let’s say WidgetCorp makes an offer to acquire Newwidget Inc for $25 per share (the stock was trading at $15 per share prior to the announcement). There is a good chance that the stock does not directly jump to $25 on the day of the announcement. There is still risk that the deal won’t be consumated; the financing could fall through, regulators could decide the deal would eliminate too much competition from the widget market, or maybe the shareholders of Newwidget will reject the deal (friendly deals close at a much higher rate than hostile takeovers). Let’s say the stock only jumps to $24.25 right away. That is when a merger arbitrage fund would step in and buy the stock. If the deal is consumated, they will make a profit of $0.75 per share. If not, the stock might drop and they lose money. As the certainty of the deal closing increases, the gap between the current price and the merger price should shrink.
You are Not Speculating on Acquisition Targets
Merger arbitrageurs do not say, a banking company out of Ohio was just acquired by a larger bank, I think we will invest in a similar banking company in Michigan because someone might want to acquire them. Additionally, they definitely do not try to trade on insider information about a merger that has been announced (unless they want to go to jail). They only invest after a merger has been announced. Note that some mutual funds aren’t pure merger arbitrage funds; they might be active in merger arbitrage but also be pure stock pickers going long or short in other stocks outside of those actively in a merger.
Goal is Modest Return but Low Volatility
Merger funds do not typically have huge returns. Their returns are often in the 3 to 5% range; however, they generally have much less volatility than the S&P 500. For instance, in 2008 when the S&P 500 dropped 40%, the Merger Fund (MERFX) only dropped 2.3%. Merger arbitrage funds have relatively low correlation with the overall stock and bond markets. Also, they have positive correlation with interest rates. Fees of merger funds are relatively high; often greater than 1% annually which can be sticker shock for someone used to investing in index funds with 0.1% or less in annual fees. A final consideration is that they often hold stocks for less than a year, so they generate regular income instead of capital gains. For this reason, many people invest in merger funds through a tax-free account.
Who Should Invest?
A typical investor is not going to go out and invest the bulk of their portfolio in a merger fund or funds on a long-term basis. The returns are not great and the investor would probably miss out in a major way if the market were to increase a substantial amount. Making a low single digit return or even negative return on a somewhat complicated trade when a plain vanilla index fund is up 20% is not something most investors would look forward to. However, many investors can and do invest a smaller portion of their portfolio (perhaps 5-10%) in a merger arbitrage fund for the diversification benefit since most funds have a low correlation with the overall stock and bond markets. Others might invest as an income alternative to bonds when they think interest rates are very likely to increase a substantial amount (rising interest rates decrease the value of bonds that you are already holding).