Arbitrage Fund: Invest in mergers

by Ian Wyatt, editor The Recovery Portfolio

The first month of 2010 has been off to a rocky start for stocks, with the S&P 500 falling 3.7%. The pullback for stocks over the last few weeks serves as a good reminder that the recovery for stocks is likely to be marked with fits and starts along the way.

The Arbitrage Fund (ARBFX) invests in mergers and acquisitions (M&A) by purchasing the acquired company's stock and typically shorting the acquirer. This strategy yields the 'spread' if and when the deal closes.

Fund manager John Orrico and his team avoid deals with low probability of closing by following a robust, time-tested model that eliminates hostile takeovers, deals that need to jump regulatory hurdles, and those requiring financing that might be difficult to obtain.

The team's tenacity avoiding risk has made the Arbitrage Fund a top performer and worthy of a four star rating from Morningstar. The fund concentrates on the roughly 70% of deals between firms with market caps of less than $600 million.

Advertisement

Merger arbitrage is a time tested, low volatility strategy designed to deliver positive returns regardless of general equity or fixed income market performance. Arbitrage is a low risk, low volatility bet. It's like picking up nickels, over and over again, rather than looking for gold nuggets.

Over the long term, the Arbitrage Fund typically returns two to three times the risk-free rate of return, similar to fixed income investments.  However, the Arbitrage Fund will deliver better returns if the equity markets rise, with lower volatility when they go down.  The fund doesn't speculate on takeover targets by going long those targets - Orrico and his team call that rumor-trage. Instead, they focus on transactions with a high likelihood of success.

The Arbitrage Fund has consistently outperformed the S&P 500.  Over the last five years the fund has generated annualized returns of 4.76 percent, nearly five percentage points ahead of the S&P 500. And over the last three years it has returned 4.94 percent annually, 12.27 percentage points ahead of the average annual gain for the S&P 500.

The Arbitrage Fund is well regarded as a good long / short fund option. Lipper named the Arbitrage Fund the Best Equity Market Neutral Fund over the last five years. The fund was also ranked a Lipper Leader in the categories of Total Return and Preservation. Morningstar similarly gives the fund high ranks, with a four star rating.

With increased uncertainty in the financial markets after the spectacular rise for stocks last year, the timing of this investment id ideal. M&A activity was severely depressed during the recent recession and credit crisis. With economic growth expected to remain slow, companies looking to expand more aggressively will look to M&A.

In the last couple years, many companies cut costs dramatically and reduced overhead. Now with the economic recovery underway and sales picking up, many companies are reporting very healthy profits. These profits are turning into healthy cash holding on company's balance sheets, and this cash can be used for future acquisitions.

The credit markets are now functioning more normally, and low interest rates make borrowing money inexpensive. The current economic environment should provide a nice tailwind for M&A activity in 2010.

Investors have already seen a pickup in M&A activity, with recent deals including Hewlett Packard's acquisition of 3Com, Dell's acquisition of Perot Systems, Cisco's acquisitions of Tandberg and Starent, and ExxonMobil's acquisition of XTO Energy.

The Arbitrage Fund provides some healthy exposure M&A activity without taking the risks associated with deal speculation. In the Recovery Portfolio we successfully dabbled in M&A arbitrage last year with our purchase of Wyeth.

As you'll remember, Wyeth was acquired by Pfizer in a deal that closed in October, and resulted in a healthy 19.6% gain for the portfolio. The Arbitrage Fund typically invests in 30 – 60 deals at any one time, with a average investment timeframe of three or four months. By owning shares of this fund, my Recovery Portfolio will gain diversified exposure to M&A activity.

This fund provides low volatility and aims to preserve capital, both of which are important goals in what remains an uncertain economic time. The Arbitrage Fund is a good substitute to fixed income investments, but also provides upside if stocks rise in 2010. I expect the fund will provide healthy returns for the Recovery Portfolio this year as we enter a more active time for M&A activity.

Learn more about this financial newsletter at Ian Wyatt's The Recovery Portfolio.