We all watched in anguish as the S&P 500 dropped -40% from October 2008 to March 2009. Even the most diversified portfolios weren't immune.
For all the talk about foreign economies being "decoupled" from the U.S. economy, foreign stocks tumbled in lock step with ours. Bonds fell. Preferred stocks fell. Aside from Treasuries and funds designed to short the market, it seemed like nothing was safe from the carnage.
But two unique equity funds held their ground. And this was no fluke. These two funds employ a strategy that ignores market conditions and appreciates even in the worst of times.
As you can see from the chart below, they barely broke stride during the last year's onslaught.
The Merger Fund (MERFX) and The Arbitrage Fund (ARBFX) are equity funds that invest primarily in companies that are being acquired. To purchase a company, the acquiring company usually has to pay a premium. Ernst and Young state that the average takeover premium in the U.S. over the long run is around +24%.
When a bid for a company is first announced, the company's stock rises, approaching the premium bid price. It approaches it -- but usually doesn't reach the bid price. After all, there is still a small, but finite, possibility that the deal will fail to close.
Merger-arbitrage funds like MERFX and ARBFX buy the shares of acquisition targets below the bid price and ride the rest of the way up until the deal is finalized -- making a small percentage off each deal. The more merger and acquisition (M&A) deals that are done, the more money they make.
One notable casualty of the financial crisis was the number of mergers, acquisitions and private equity deals. There were far fewer lenders willing and able to finance takeovers, and only the largest cash-rich companies could pull off acquisitions of any size.
But that is changing.
Companies have repaired their balance sheets and are looking to score a deal. More credit is available and there is a lot of pent up demand that appears to be breaking loose. Every Monday, there seems to be a slew of new M&A announcements. This week it was the drug maker Abbott Laboratories (NYSE: ABT) buying a unit of Solvay. And Xerox (NYSE: XRX) announced its agreement to buy Affiliated Computer Services (NYSE: ACS).
A few weeks ago, Warner Chilcott (Nasdaq: WCRX) agreed to buy Proctor & Gamble's (NYSE: PG) drug business. Dell (Nasdaq: DELL) offered to buy Perot Systems (NYSE: PER). And Kraft (NYSE: KFT) is still tussling with an unsolicited bid for Cadbury (NYSE: CBY).
So even if that market correction never comes (fingers crossed), it looks like merger-arirs109trage funds may be heading into a very lucrative period. (To read about another way to profit from the M&A boom, go here.)
Merger-arbitrage funds have sizable costs because of the amount of turnover in the funds. As a result, their expense ratios are higher than most investors are used to -- between 1.5% and 2.0%. Also because they hold securities for relatively short periods of time, they throw off a lot of short-term capital gains. So they are best held in a tax-deferred or tax-free account.
But these seem like relatively small inconveniences for investments that have proven track records in market downturns and appear to be heading for higher ground.