Does a stock fund that consistently generates low-single-digit returns deserve a place in the Kiplinger 25? The answer, we think, is yes--if the fund in question practices a strategy that's so tame that its risk profile is closer to a medium-maturity bond fund's than a stock fund's.
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At issue is the performance of Merger Fund (symbol MERFX), which over the past year has returned a piddling 3.0%, 15.2 percentage points less than Standard & Poor's 500-stock index (all returns are through September 13). As its name suggests, the fund invests in companies that will soon merge or be acquired. But rather than aiming for a killing by trying to identify future buyout candidates, Merger invests in a targeted firm after a deal is announced and its share price has jumped sharply (as often happens). The fund's goal is to capture the final bit of appreciation between the post-announcement price and the price at which the deal is consummated. The fund's success, or lack thereof, depends primarily on the ability of its managers, Roy Behren and Mike Shannon, to invest in deals that go through. "We're selective," says Behren. "We're not an index fund of merger transactions because that's where we add value."
That's largely because broken deals often end in big drops in the share price of the formerly targeted company. If the managers were to invest in every announced deal, Behren says, the bets would work out 90% of the time. But the losses due to the broken deals would be so large that they'd offset much of the gains reaped from successful deals.
Behren and Shannon have a success rate of about 98%. They invest in 40 to 60 deals at any given time and typically see just one to three of them fall apart per year.
They also are careful to avoid deals that don't offer a meaningful potential return for the risk that the transaction will fall apart. Leveraged buyouts sometimes fall into this category. One such deal: In late May, Apax Partners, a U.K.-based private-equity firm, announced that it would purchase Rue 21, the discount fashion retailer for young men and women, for $42 a share and take it private. But two days after the deal was announced, Rue 21's stock closed at $42.03. It subsequently dropped below the deal price, but never far enough below it to provide Shannon and Behren enough potential gain to offset the risk that the share price could plunge if the deal collapsed.
Meanwhile, the managers have earned solid returns in some recently closed deals. The pair bet on BMC Software earlier this year after a group of investors led by two private-equity firms, Bain Capital and Golden Gate Capital, announced that it would take private the business-services software company. The deal closed in May, and the fund made about 7% on an annualized basis. More recently, Shannon and Behren bought shares in Astral Media, which was coveted by Bell Canada for its specialty TV channels and radio stations. The deal, first announced in early 2012, nearly fell apart when Canadian regulators expressed objections in October 2012. But after consulting telecom lawyers in Canada, the pair felt comfortable that Bell Canada "was committed to the transaction and was willing to make the changes to get approval from regulators," says Behren, and they even picked up more shares in Astral Media. In the end, they were right. Bell agreed to sell some of Astral's TV channels and radio stations to seal the deal--and Merger earned a 12% annualized return when the transaction closed in June.
The managers say low interest rates are hobbling returns. That's because the potential gain from investing in a target after a deal is announced is connected to rates. A typical gain ranges from two to five percentage points above the yield of ten-year Treasury bonds, which Behren and Shannon use as a proxy for the risk-free rate of return. Thus, low rates have meant lower returns for practitioners of merger arbitrage. That also means returns should rise as interest rates do. "We would expect our returns to increase in such an environment," says Behren, who joined the fund in 2007, as did Shannon.
That makes the fund a great portfolio diversifier, and many advisers are investing in Merger as a hedge against rising rates. "Some advisers use the fund as an alternative investment or a market-neutral strategy," says Behren, "but the latest trend has been to use it as a bond fund substitute."
Over the past five years, Merger has been 18% less volatile than the typical taxable intermediate bond fund (and about 80% less jumpy than the S&P 500). Merger has also posted lower returns: Its 3.3% annualized gain over the past five years trails the results of taxable intermediate-term bond funds by an average of 2.2 percentage points per year and of the S&P 500 by an average of 5.3 points per year. But if interest rates do continue to rise--which would certainly hurt bond funds and could help Merger--those relative standings could change quickly.