Merger Arbitrage Funds: The Weak Link

Several years ago, I invested in a mutual fund called Arbitrage Fund (ARBFX) for a short period of time (less than two years). The reason for me to get into this fund was that the fund’s investment strategy is different from any other funds I invested in and I was looking for an investment with weak correlation with the broad market. ARBFX, along with a few other funds, belongs to a category whose investment strategy takes advantage of the price discrepancy in the merger or acquisition activities.

What’s merger arbitrage fund

Unlike the majority of mutual funds, index or actively managed, which seek either growth or value of underlying companies, merger arbitrage funds invest in companies that are subject to merger or acquisition and make profits from the expected price change following the announcement of the deal.

According to Investopedia, merger arbitrage is

a hedge fund strategy with which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. A merger arbitrageur looks at the risk of the merger deal not closing on time or at all. Because of this slight uncertainty the target company’s stock will typically sell at a discount to the price that the combined company will have when the merger is closed.

How merger arbitrage fund works

To illustrate how merger arbitrage funds work, suppose that Company X, currently traded at $15 a share, is the takeover target with the purchase price of $20 a share. After the deal is announced, the share price of Company X is expected to rise, but may not reach the target price as there’s possibilities that the deal could fall apart. If Company X’s stock is traded at $19 instead of $20, a fund engaging in merger arbitrage will then purchase Company X’s stocks and, at the same time, short the company that buys Company X, anticipating that the deal will eventually go through and Company X’s stock will reach the target price of $20/share.

In this case, the arbitrage fund captures the $1 difference (the spread) between the price when it purchased shares of Company X and the target price when the deal completes. The return of the fund by investing in Company X is 1/19 = 5.26%. The annual return of the fund depends on how long it takes the deal to complete. If, for example, the completion of the acquisition of Company X uses four months, then the annual return = (12 months)/(4 months) * 5.26% = 15.78%.

Pros and cons of arbitrage funds

From the above example, we can see that whether the arbitrage fund can profit by investing in Company X is determined by whether the announced acquisition can go through. Thus, the profit of the fund employing the merger arbitrage strategy has relatively weak correlation with the performance of the broad market, offering a certain degree of diversification.

The risk facing arbitrage fund, obviously, is that the merger or acquisition could fail. To reduce such risk, the arbitrage fund could invest in friendly deals, which have a higher possibility of success. In addition, the fund usually invests in multiple deals at the same time to mitigate the risk of failing deals. Then, if the deal is a sure thing, the spread will be small, leading to lower returns. Also, if the deal takes longer than anticipated time to complete, the annual return of the fund investing in the deal will be reduced even more.

Merger arbitrage funds

In addition to ARBFX, another bigger player in merger arbitrage is Merger Fund (MERFX), which has about $1.9B in assets.

As M&A booms in recent years, one may think that funds such MERFX and ARBFX should enjoy some good times. Well, not so. According to Morningstar, the 5-year return of MERFX is 6.82%, lagging S&P 500 by 5.85% (shown in the above plot) and ARBFX recorded a far inferior 5-year return of 5.32%. While these funds posted lackluster returns in extended periods, they are not cheap to own. MERFX’s expense ratio (ER) is 1.37% and ARBFX has a ridiculously high ER of 1.95%.

While merger arbitrage funds may offer weak correlation between the fund’s performance and the movement of the overall market, their returns are pretty weak as well, making the high fees of these funds unjustified.

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