Investment bankers are not the only ones that can benefit from merger arbitrage. Often considered a sophisticated hedge fund strategy, merger arbitrage involves simultaneously purchasing and selling the stocks of two merging companies to create limited market-neutral profits. A merger arbitrageur reviews the probability of a merger not closing on time or at all, and purchases shares of the takeout target while the stock trades at a slight deal premium due to investors wanting instant liquidity or deal price uncertainty. Individual investors can attempt to do this on their own, however, there is one fund company that has a proven track record at doing this for us: Westchester Capital, and The Merger Fund (MERFX).
Why Merger Arbitrage?
Merger arbitrage is an absolute return strategy that seeks capital growth by investing in companies involved in pending mergers, takeovers and other corporate reorganizations, with the goal of realizing full profits from the real transaction price. This type of strategy is an interesting asset class, since it is not passive, and not actively trying to predict how individual companies are going to perform long term. Investment professionals within this niche understand the deal dynamics, and what the risks are that allow investors to make smaller and more consistent profits.
The size of this discount, known as the arbitrage “spread,” is influenced both by general market conditions, as well as by deal-specific considerations that affect the transaction’s timing and perceived probability of success. Since this type of strategy is deal-specific, we cannot just lump this into a long-only equity strategy. This in return allows less correlation than just buying equities and bonds.
As the S&P 500 collapsed in the fourth quarter of last year, MERFX gained. The $3 billion Merger Fund returned 7.7%, as the S&P 500 was flat on the year.
As you can see from the above chart, MERFX provided investors a very low correlation to equities. MERFX seeks to realize consistently high risk-adjusted absolute returns with low market correlation, while maintaining a primary emphasis on preservation of capital. Westchester Capital does not speculate on future takeover targets or invest based upon rumors for MERFX. It achieved this return profile by its merger arbitrage strategy – buying shares of the target company, which tend to rise immediately following the announcement, and selling or shorting the acquirer, expecting to make a profit when the acquisition is completed. Since 1989, the Merger Fund has evaluated more than 10,000 potential transactions, and invested in over 4,500 corporate reorganizations of which over 98% were completed. This is quite a track record that is tough to beat. Let’s take a look at the annual returns since 1990:
(Source: Portfolio Visualizer)
What’s The Catch?
As with any investment, you can have all the return numbers in the world, but you need to know the catch. For example, a merger may not go through due to a number of reasons. One of the companies may not be able to satisfy the conditions of the merger, shareholder approval may not be obtained, or, regulatory issues (such as antitrust laws) may prevent the merger. This is of course deal-by-deal risk, which should actually make you want to use a fund such as MERFX that has such a high probability of finding successful mergers.
A specific risk to MERFX is the drawdown that it can experience. Coming out of the tech bubble in 2002, the fund experienced a -14% peak to trough loss. Now, this is much lower than that of the Nasdaq (QQQ) at the time, but still is a hefty price fluctuation. Investors should not buy this fund believing that the price will not fluctuate. However, when we pull up the risk metrics, MERFX comes in at a standard deviation of just 4.64%. The standard deviation figure gives us a quantitative measure on how much the stock could fluctuate up and down for the year. Let’s take a look below at a few more key risk ratios:
|Arithmetic Mean (monthly)||0.50%|
|Arithmetic Mean (annualized)||6.16%|
|Geometric Mean (monthly)||0.49%|
|Geometric Mean (annualized)||6.05%|
|Downside Deviation (monthly)||0.91%|
|US Market Correlation||0.47|
(Source: Portfolio Visualizer)
When we comb through the other above risk metrics, it becomes pretty hard to outline any more risks to the fund. With a U.S. market correlation of .47, this fund delivers an alternative to traditional equity risk. It does this by only being 15% sensitive to any given day’s worth of market action. For investors looking to invest new capital, this can be a fund that you can average into while not worrying about everyday stock moves. It is not a bond fund or an equity fund focused on long-term capital appreciation. You could look at this fund as a type of market-neutral asset since it buys shares in takeout targets and shorts the acquirer in certain circumstances.
Going Forward And Summary
As stocks are hovering around record highs, it is becoming more difficult to find asset classes and mutual funds that investors can purchase right now. MERFX is a perfect fit for investors who are looking for little correlation to equities, and not wanting to chase long-term bond fund returns. Westchester Capital and the MERFX fund seeks to invest in those transactions that provide the highest risk-adjusted returns, and not those that produce the highest returns without regard to potential drawdowns.
Since 1989, the MERFX has produced annual returns of 6%, with its best year returning over 17.69%, and its worst year only losing -5.67%. When looking for alpha, the MERFX is delivering. One more thing to note is that MERFX does have a higher than average expense ratio of 1.6%. However, when you consider they have only lost money in three of the thirty years, it’s tough to criticize the higher expense ratio. If you are a retiree, the MERFX has also produced 266 monthly gains out of 357 total.
The returns are consistent to say the least. The future looks bright for this fund as M&A continues to be strong as more deals are announced. Companies continue to accumulate more debt and have less cash, but funding costs are lower and acquirers continue to get banks’ support as well as access to credit. Moreover, corporate valuations (and hence M&A opportunities) remain affordable to say the least. When considering to put new money to work, take a serious consideration of the MERFX fund.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Ortner Capital consults clients who could potentially purchase MERFX in the future. These are professional opinions of Mr. Josh Ortner, CTFA, and not personal financial advice.