To most people, the words "merger and acquisition arbitrage" summon images of frenzied traders with both ears glued to the telephone, making and losing money with gut-wrenching speed. Big potential returns are accompanied by big potential risks. So how is it that The Merger Fund, which specializes in that little-known and even less-understood corner of the investment world, has managed to produce positive returns year after year, with about one-fifth the volatility of the overall market?

"Done properly," says Bonnie Smith, who co-manages the fund with Fred Green, "merger arbitrage can be one of the most conservative equity investments around. The beauty of it is that returns have very low correlation to the overall stock market, which is one reason we have been able to produce attractive rates of return, even in flat or down markets." The fund's goal, say its managers, is to achieve a 10% to 15% return over the long term.

That might sound like pretty tame stuff when stocks are returning upwards of 20% a year. But while the fund may lag the averages in strong bull markets, its consistency in both rising and falling markets has drawn investors seeking a less volatile alternative to plain-vanilla stock funds.

In 1999, for example, a strong year for both merger and acquisition activity and the stock market, the fund clocked a not-too-shabby 17.4% total return, compared with 21% for the S&P 500 Index. In 2000, when the index fell 9%, the fund rose 17.6%. Last year, the fund rose 2%, compared with a 12% drop for the S&P. The fund has never had a down calendar year since its inception in 1989, and has had only seven quarters of negative returns during that period.

Those steady returns and low stock market correlation have made The Merger Fund a portfolio ballast for some financial advisors. "It's one of my biggest holdings," says Lou Stanasolovich, CFP, president of Legend Financial Advisors in Pittsburgh. "I use it as a hedge in my traditional portfolios and as a core holding in lower-volatility portfolios."

But with mergers crawling along at a snail's pace and some deals in limbo, merger arbitrage is far from a clear path to profit these days. Last year, the Merger Fund's 2% total return, while beating the 12% drop for the S&P 500, was a far cry from its historic average. So far this year, the fund is down about 2%.

A Pause At The Altar

Merger activity, the lifeblood of The Merger Fund, began slowing down early last year and ground to a virtual halt in the third quarter. While the 0.8% drop in the fund's net asset value was relatively benign compared with the 15% decline for the S&P 500 over the period, it reflected how far companies had strayed from the acquisition trail.

If not for the fund's high cash balance at the beginning of September, things could have been much worse. With the slowdown in activity earlier in the year, and more people chasing fewer deals, arbitrage spreads narrowed, and Smith and Green decided it was time to step back and wait for conditions to improve. By late summer, they had about 30% of the fund in cash, its highest allocation ever.

Then came September 11. In the aftermath of the attacks, says Green, "deal spreads widened dramatically, across the board. And we're not just talking about riskier deals, but deals in general." By the end of that month, the pair had put $300 million, or nearly all of the fund's cash balance, back to work. In early October, they decided to re-open the fund, which had closed to new investors in August 1999.

The decision to jump back in with both feet came in part from the fact that many merger agreements make it extraordinarily difficult for companies to head for the exit door. "Most merger agreements do not allow companies to terminate because of general events," says Smith. "You can't stop a deal based on the state of the economy or a fluctuating stock market. There needs to be one, specific problem." Smith says that none of the approximately 40 deals in the portfolio were terminated in the aftermath September 11, and that she is aware of only about a half-dozen, mostly smaller deals that were called off.

Still, companies remain firmly in the grips of merger-phobia. By the end of 2001, companies had announced 7,596 deals for the year valued at $793 billion, according to Thomson Financial. That anemic pace stood in sharp contrast to the frenetic pace of 2000, when companies announced 11,077 deals valued at $1.74 trillion.

This year is shaping up as a virtual drought, with only 2,350 announced deals valued at $145 billion as of mid-May. Green attributes the slowdown to an uncertain economy, general corporate malaise, and a dash of Enronitis. "Corporate America remains skeptical," he noted in a recent letter to shareholders. "Many executives fail to see much near-term improvement in their own businesses, and they view longer-term revenue and earnings forecasts-the kind needed to appropriately price mergers and takeovers-with even greater caution. In the wake of the Enron debacle and the collapse of other companies that once enjoyed huge market capitalizations, doubts about corporate accounting policies only make matters worse."

Companies are also having a tougher time selling transactions to Wall Street because recent high-profile mergers have failed to deliver promised benefits, he says. Agreeing on a fair price is another issue. "There has been a big disconnect between buyers and sellers," says Green. "Buyers are out there looking at today's prices, while sellers think they deserve values that were out there a year ago. Sellers need to get real."

With all the uncertainty in the air, the fund has only about 70% of its assets invested in roughly 33 arbitrage positions. Smith and Green have also expanded their holdings in bonds of target companies, which they say can offer returns comparable to equities, but with lower risk.

Despite the cautious environment, Smith and Green say there are signs that the M&A cloud may lift, perhaps as early as later this year. As an improving economy and business conditions help corporate executives focus on strategic thinking rather than damage control, companies holding back on acquisitions now may decide to move forward.

Playing The Game

The performance of The Merger Fund has less to do with the overall direction of the stock market than the success or failure of its merger-related hedging strategies, which seek to lock in appreciation on stocks targeted for takeovers.

A target's stock price often jumps on the announcement of a takeover, since the acquirer typically offers a premium over market value to sweeten the deal. For example, a target company's stock selling for $25 a share the day before a $35-a-share acquisition announcement may jump to $33 soon after the announcement is made. The shares usually won't rise to the full takeover value, however, since the transaction could hit a snag and fall through. A big disparity between the market price after the announcement and the acquirer's offer means that investors are fearful that the deal will be canceled or delayed, while a narrow spread indicates confidence in a swift and successful conclusion.

Merger Fund managers Bonnie Smith and Fred Green focus on how likely, and how quickly, an announced deal will get done. After analyzing a deal, they decide whether they will jump in or sit it out because of potential gotchas, such as antitrust or regulatory concerns, or even a brewing personality clash between management teams. To find those red flags, they interview executives, government regulators and analysts.

The fund's investment strategy depends largely on how the acquirer plans to finance a takeover. In a transaction where a company plans to acquire shares with cash, the fund may simply buy shares of the target company and wait for them to go up to the takeover price when the deal is completed. If an acquirer is using its stock to affect the takeover, there's a risk that the stock will fluctuate in the months it takes to complete the deal. To defuse that risk, Smith and Green usually purchase the target's stock, while simultaneously selling short the shares of the acquirer. Investors should note the fund's arbitrage strategies create high portfolio turnover, and almost all gains are short term, making them taxable as ordinary income.

In most deals, the fund builds or adjusts its positions as the proposed transaction moves closer to completion. "We don't just take a big position the day a deal is announced and wait until it's concluded," says Green. "We keep on top of how things are progressing and adjust our strategy accordingly." If a deal moves along smoothly and the prices are right, the fund might add to its position. But if things begin to look uncertain, the portfolio managers may unwind a position.