Wealthy investors have long prized merger arbitrage hedge funds because they are seen as safe. Most deals do close and generate small profits for arbitrage investors. More importantly, the merger funds offer diversification since the returns are not necessarily dependent on the direction of the overall stock or bond markets

The returns of merger funds tend to track interest rates. As rates climb, so do returns. This occurs because merger investors shy away from deals unless they promise to deliver returns in excess of the risk-free rates of Treasury bills. Under normal circumstances, promising deals tend to produce annualized returns that are about 4 percentage points above yields on Treasury bills.

If Treasury bills yield 2%, then investors will not buy a deal stock until they can get annualized returns of about 6%. When Treasury rates rise to 3%, investors will seek to obtain returns of 7%. If the spread between the current share level and the final deal price is too narrow, merger investors will sit on the sidelines until the price sinks.

At the moment, three-month Treasury bills yield almost nothing, so safe deals promise to generate annualized returns of about 4%. In a pending deal, Hanesbrands ( HBI) announced it would pay $23.50 a share for Maidenform ( MFB). The shares currently trade for $23.38, and the deal is expected to close in the fourth quarter. If things run smoothly, investors could obtain annualized returns of about 4%.

To spread its bets, Arbitrage Fund typically invests in 40 to 60 transactions. While some deals close in 30 days, others take several months. The aim is to book quick gains, and then reinvest the proceeds in other deals. If a deal turns sour, the managers cut their losses and move on to more promising opportunities. Portfolio manager John Orrico holds a mix of different kinds of deals, including safe choices and riskier opportunities that can deliver higher returns.

Among his riskier positions currently is Dell ( DELL). The shares trade for $13.73, and a group led by Michael Dell has promised to pay shareholders a package worth $13.95. Orrico figures that the deal will close in October, producing an annualized return of around 9%. Carl Icahn and some other big shareholders oppose the deal. But Orrico thinks that the acquisition will close because many shares are now in the hands of arbitrage funds that would profit from the sale.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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