In 2015, mergers and acquisitions (M&As) in the United States were at an all-time high, with volume reaching $4.9 million across most sectors. Although the trend is expected to slow a bit in 2016, conditions for profits remain very good for certain sectors and among smaller and mid-sized companies. Many analysts expect the activity to continue at a high level in the technology and health care sectors, while the energy and financial sectors should see upticks in activity this year. There is still an opportunity to participate in the M&A arena with positive results, and the best way to do so is through merger-arbitrage mutual funds.
Mutual funds that invest in M&A activities are not looking to score the big deals ahead of everyone else. Instead, they tend to look for deals that have already been made, but have not yet been completed. When a deal is announced, the mutual funds buy shares of the target company if they believe the share price is still selling below the premium price it will ultimately achieve when the deal is completed; this is called the deal spread. The funds can also short the acquirer's stock if they believe the deal will result in their share prices declining. The profits are made when the deal is completed.
The investment strategies of many of these merger-arbitrage mutual funds are very conservative, typically resulting in modest but steady returns. Once the deal spread is determined, the fund manager develops a risk/reward profile. To counter a possible stock price decline due to a deal falling through, the fund can hedge the position with options or long/short positions to minimize its risk. These funds tend to be less volatile because they have low correlations to the stock market. However, merger-arbitration funds do a lot of trading, resulting in higher transaction costs and taxes. They also tend to have higher expense ratios, which can eat into returns.
The Arbitrage Fund (ARBNX)
The Arbitrage Fund Institutional Class ("ARBNX") is one of the larger merger-arbitration funds, with $2 billion in assets under management (AUM). The fund utilizes a proprietary selection process to screen a universe of 150 to 200 U.S. and foreign M&A deals. After analyzing how likely and how quickly deals will get done, it narrows the universe down to 40 to 80 deals it holds in its portfolio at any time. As of March 18, 2016, the fund had 73% of its assets invested in stocks, with the remaining in cash. Its highest weightings were in the technology and financial services sectors, with smaller weightings in industrials, health care and consumer cyclicals. The fund's top five pending deals making up 27% of the portfolio are PartnerRe Ltd., which was acquired by Exor SpA (OTC: EXOSF) in late 2015; Precision Castparts Corporation, which was bought by Berkshire Hathaway, Inc. (NYSE: BRK-B) in 2015; Cytec Industries Inc. (NYSE: CYT); Chubb Ltd. (NYSE: ACE); and Health Net, Inc. (NYSE: HNT).
The fund has returned 3.22% over the last 10 years, as of 2016, and a 2% return over the last five years. The fund’s expense ratio is 1.2%. The minimum investment amount for the institutional class of the mutual fund is $100,000. For the retail class ("ARBFX"), C shares ("ARBCX") and A shares ("ARGAX"), the minimum investment is $2,500, but the expense ratios are higher (1.45 to 2.2%).
The Merger Fund (MERFX)
Launched in 1989, the Merger Fund Investor Class ("MERFX") is considered the grandfather of merger-arbitration funds. It is also the largest with $4.2 billion in AUM. Because of its size, it has to focus on larger deals. However, it also invests in smaller deals when the opportunities arise. As of March 18, 2016, the fund’s top holdings were Precision Castparts, Time Warner Cable, Inc. (NYSE: TWC), Broadcom Corporation (NASDAQ: BRCM), Chubb and PartnerRe. The fund has returned 2.91% over the last 10 years and 1.71% over the last five years. The minimum investment is $2,000, and the fund's expense ratio is 1.34%.
The Gabelli ABC Fund (GABCX)
When the Gabelli ABC Fund Class AAA ("GABCX") is looking for M&A deals, it acts very much like a value investing fund, investing in companies with stocks that are selling well below their intrinsic values. The $1.4 billion fund has plenty of M&A deals to keep it busy. Its most profitable deal in 2015 was the purchase of Salix Pharmaceuticals Ltd. by Valeant Pharmaceuticals International, Inc. (NYSE: VRX) for an annualized return of 75%. As of March 21, 2016, the fund was holding 57% of its assets in cash and 40% in stocks. Its top five holdings are StanCorp Financial Group, Inc. (NYSE: SFG), Dyax Corporation (NASDAQ: DYAX), Lennar Corporation (NYSE: LEN), Airgas, Inc. (NYSE: ARG) and BioMed Realty Trust, Inc. (NYSE: BMR). Over the last 10 years, the fund has returned 3.77% , and over the last five years, it has returned 2.93%. The fund’s minimum investment is $10,000, and its expense ratio is 0.59%.