Why You Should Consider Investing in Merger Arbitrage Funds

NEW YORK (TheStreet) -- Markets and investing have become more complicated in 2014 compared to last year. The bull market in stocks is showing signs of age, while bond investors are trying to figure out whether Federal Reserve tapering will lead to higher interest rates.

That means now is the time for investors to seek ways of reducing their portfolios' volatility, both in equities and fixed income. One way is merger arbitrage funds, such as the Merger Fund (MERFX) and the Arbitrage Fund (ARBFX). Both of them practice what's known as merger arbitrage, betting that shares of the acquired company will rise while those of the acquirer fall.

An article this past weekend in Barron's noted the funds' steady returns and low volatility. In addition, these funds tend to trade differently from both equities and fixed-income securities.

The broad strategy is that the after a merger is announced a merger fund will buy the stock of the company being acquired and sell short the shares of the acquirer to capture the spread between the two until the deal is finalized. Because these funds incorporate both long and short trading, their volatility in general should be lower than that of the typical equity fund.

The Merger Fund and the Arbitrage Fund are mutuals funds, but there are also several exchange-traded products that follow a similar strategy, including the Credit Suisse Merger Arbitrage Liquid ETN (CSMA) and the Index IQ Merger Arbitrage ETF (MNA).

It's important to note that these four funds do not have identical holdings and use different tactics.

The Credit Suisse Merger Arbitrage Liquid ETN goes long the company being acquired but will only short the acquirer if it is using its own stock for the deal.

If the acquirer is buying the other company with cash, however, the Credit Suisse fund will simply hold cash instead of a corresponding short position. This fund has a 0.55% expense ratio. Technically, it's an exchange-traded note, which means CSMA does not own the underlying positions. Rather, it is an unsecured debt obligation of Credit Suisse that tracks an underlying index.

The Index IQ Merger Arbitrage ETF does not short individual stocks but instead creates short exposure by using broad-based indices. It has an expense ratio of 0.77%.

Both the Merger Fund and the Arbitrage Fund are actively managed funds as opposed to funds that simply track indices. As such, they are more expensive than the ETFs. The Merger Fund has an expense ratio of 1.27%, while the Arbitrage Fund has a ratio of 1.45%. They are also much bigger, with assets in the billions. The Credit Suisse Merger Arbitrage Liquid ETN has only $51 million, while the Index IQ Merger Arbitrage ETF has just $25 million.

While there is a lot of overlap among the four funds' holdings, the process for weighting from fund to fund is different. For the Credit Suisse Merger Arbitrage Liquid ETN, the larger the dollar value of the deal, the larger its weight in the fund. Index IQ Merger uses a quantitative model to score the probability that the deal will be finalized before including it in the fund. The actively managed Merger Fund and Arbitrage Fund can also add qualitative factors to the process.

Over the last one-year and three-year periods, the Index IQ Merger Arbitrage ETF has been the performance leader, gaining 7.3% and 7.5%, respectively. The other funds have had smaller returns during those periods.

The outperformance of the Index IQ fund doesn't necessarily mean it is the best fund. Future returns are of course unknowable. It would be reasonable to wonder whether the fund that went up the most during a huge multiyear rally would be the one to go down the most during the next bear market.

Morningstar provides data that provide some context of how low the volatility of these funds can be. According to these data, the Merger Fund has a standard deviation of 2.64, the Arbitrage Fund is at 2.48, the Credit Suisse ETN comes in with 3.85 and the Index IQ fund registers 4.68. The S&P 500, meanwhile, is 12.4.

Funds in the merger-arbitrage space may also play a role in a portfolio as a substitute for bonds funds if and when interest rates move higher. Not that the merger funds will be good sources of yield -- past payouts have been sporadic where there have been any -- but where the idea is dampening the volatility of the equity portion of the portfolio these funds have merit.

At the time of publication, Nusbaum owned shares of MERFX.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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