Low-risk merger arbitrage may seem like a contradiction in terms. But a decade ago, Barron’s declared the Merger Fund, which – you guessed it – engages in a merger arbitrage strategy, “one of the safest stock funds you can buy.” The shoe still fits. The fund boasts a beta of 0.25, making it 75% less volatile than the Standard & Poor’s 500, and is more than a full standard deviation lower than the mean for mutual funds.
With the mergers and acquisitions market heating, and a growing number of so-called hedge fund-like mutual funds beginning to crowd the field, the Merger Fund is set to rejoin the fray; the fund is reopening to new investors today, after staying shut for almost two years.
“We closed the fund again in March of 2004,” co-portfolio manager Bonnie Smith explains, as M&A activity slowed and “we just felt at that point we didn’t want any new money coming in.”
The fund, which launched in 1989, has a history. It shut the doors to new money the first time in 1996, reopening two years later to take advantage of the Russian debt crisis and the collapse of hedge fund Long Term Capital Management, which was selling its merger arbitrage portfolio. It didn’t stay open for long, closing again the next year, and remaining shut until October 2001. How long it stays open this time around is anyone’s guess.
“It’s a fluid situation,” Smith says. “We’re always trying to decide if the current investors are being served well if we keep the fund open.”
Since closing in 2003, the $1.2 billion Merger Fund – the only such offering; there is a variable life clone of the fund in addition to the main fund – offered by Valhalla, N.Y.-based Westchester Capital Management –-- hasn’t had the easiest time of things. The fund returned only 2.71% in 2004, and 0.8% last year, following a disastrous fourth quarter.
“October was just a dreadful month,” Smith said, calling the month one of the worst she had ever seen, with four deals failing to pan out. She runs the fund, and advises hedge funds, along with co-portfolio manager Frederick Green. The fund lost 1.5% during the quarter. Still, the fund has been in positive territory 16 out of 17 years, and the new year has brought some good news.
Notably, medical device maker Guidant, in which the fund has a big stake, took two big regulatory hits in 2005, forcing it to stop selling some of its defibrillators, followed by a recall of some of its pacemakers. Johnson & Johnson, which had agreed to buy the company for $25 billion, started making rumblings it wanted out of the deal. Instead, the two companies opted for a revised, much less rich agreement, with J&J shaving $13 per share from its offer.
In December, however, medical device maker Boston Scientific saved the day for fund, offering $72 per share for Guidant, and prompting a bidding war with J&J that apparently ended, conveniently enough today, with J&J not responding to Boston’s $80 per share, $27 billion offering.
"[October] was painful to go through, but at the same time, it created opportunities,” she says. Spreads began to widen, thanks in part to rising interest rates. What’s more, M&A activity has been on the rise, with “consolidation in the energy sector, technology, health care, just across the board.” Financials is always ripe for M&A activity as well. Smith notes that “there are too many banks in this country.” She and Green “expect [the higher activity] to continue” in 2006.
For investors who consider “skin in the game” important, this could be the fund. We have our entire pension fund, for Fred and me and everyone else at Westchester Capital, invested in the fund,” Smith notes, “so we’re all in this together.”
Nor is she concerned with the end of the interest rate cycle, which will likely come this year. Indeed, she says she has mixed feelings about rising rates, which will help spreads, but may make deals too expensive for acquirers: With most deals paid for in cash, Smith says “it’s important to have favorable rates for the acquirers to borrow at.”
Indeed, Smith says she’s “relatively indifferent to what goes on” in the economy, and that her picks are not speculative. “We’re not proactive here, we’re reactive,” only buying after a deal has been publicly announced, which does lead to a big downside.
“You really need to have a 95% success rate,” she says, “because when we purchase a stock, it’s already run up.” When deals do fall through, and that stock price falls back to earth, the fund takes a big hit.
The fund’s big attraction isn’t the kind of outperformance opportunity that a large-cap growth fund offers in a bull market, but its risk metrics.
“There aren’t too many mutual funds that have the numbers we have regarding beta and standard deviation,” Smith argues. “We are as market neutral as one can get in a mutual fund.”
It’s that diversification opportunity that draws financial advisers – Smith says the majority of her investors come through the fund supermarkets – to the Merger Fund. And now, they are being welcomed back.