Merger Funds Rejoice as Deals Surge

NEW YORK (TheStreet) -- As the markets stabilize, acquisitive companies are putting their money to work. Berkshire Hathaway(BRK.A) is planning to buy Burlington Northern Santa Fe(BNI), while Exxon Mobil(XOM) is bidding on XTO Energy(XTO).

Increasing deal activity is welcome news for merger funds, which invest in shares of acquisition targets. Some merger funds had to hold cash or invest in shaky transactions after the M&A market dried up in 2008. Now fund managers will be able to shop more selectively.

"The environment is right for a continued increase in merger activity," says Tony Davidow, executive vice president of IndexIQ, which manages the IQ ARB Merger Arbitrage(MNA) exchange traded fund. "Companies have record amounts of cash on their balance sheets, and they are looking for ways to increase revenues."

Instead of shooting for home runs, merger funds aim to deliver a consistent small gains. The funds often outperform the S&P 500 Index during downturns. That has made merger funds particularly appealing in the difficult markets of recent years.

The Merger Fund(MERFX), a mutual fund, has returned 4.7% annually, on average, during the past decade, outpacing the S&P 500 by 5 percentage points, according to Morningstar(MORN). The fund returned 17% in 2000, a year when the S&P sank into the red. In 2008, Merger Fund lost 2%, outpacing the S&P by 35 percentage points.

Merger funds aim to profit from situations where a stock trades at a discount to the announced takeover price. Say a stock is trading at $9, and an acquirer announces that it will buy the shares for $11. After the announcement, the target stock may trade at $10. The shares trade at a discount to the takeover price because investors worry the deal may collapse. If that happens, the stock could fall back to its original price. When a deal seems unlikely to close, the discounts can widen.