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%.

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