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Why Rising Interest Rates Could Help Merger Funds

NEW YORK ( TheStreet ) -- Worried about rising interest rates, investors are scrambling to protect their portfolios. Many are dumping bonds and dividend-paying stocks, which tend to do poorly when rates climb.

What investments will thrive when the Federal Reserve finally raises rates? Among the likely winners are merger funds, which buy the stocks of companies that are being acquired.

Top-performing mutual funds include Merger Fund (MERFX) and Arbitrage Fund (ARGAX). ETF investors can try IQ Merger Arbitrage (MNA).

Merger funds delivered solid results throughout the last big run-up in rates, which occurred in the three years that began in 2004. During that time, the Federal Reserve raised the federal funds rate from 1% to 5.25%. For the period, Merger Fund returned 5% annually, topping the average intermediate government fund by a wide margin. "When interest rates rise, bond investors have the wind in their faces, but we have the wind at our backs," says John Orrico, portfolio manager of Arbitrage Fund.

In up and down markets, the merger funds churn out modest results, delivering single-digit returns almost every year. During the past 10 years, Merger Fund and Arbitrage Fund both returned 3.8% annually, according to Morningstar. The funds outdid the average short-term bond funds, while being only a bit more volatile.

"Merger arbitrage is a way to preserve wealth, not necessarily an easy way to become rich," says Paul Rosenberg, portfolio manager of Catalyst Event Arbitrage Fund (CEAAX), a mutual fund that invests in merger stocks.

In a typical deal, a fund buys the shares of company that is about to be acquired. Say an acquirer announces that it will pay $12 a share for the target stock, and the deal is expected to close in two months. Before the deal is completed, the shares may trade for $11.50 because investors worry that the sale could be scotched by regulators or other problems.

If that happens, the shares could sink well below the proposed acquisition price. The merger investor buys the shares, betting that the deal will close. If the acquisition happens on schedule, the investor pockets profits of $.50 a share. Such small gains can add up to single-digit annual returns.

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