But when Index IQ back tested the results of their methodology for the years 2003 through 2007, the data showed the S&P 500 rose 82 percent during that time versus a 76 percent gain for the hedged arbitrage strategy. But the merger arb approach also produced much lower volatility, so it handily outperformed the S&P 500 on a risk-adjusted basis. The fund’s top positions currently include Plains Exploration, NYSE Euronext and Nexen, all of which are trading ever closer to their buyout price.

Unshackling The Upside

The ProShares Merger ETF (MRGR) doesn’t place as strong an emphasis on hedging, doing so only when some or all of a company’s stock is used to buy another firm. As a result, its returns should be even more robust in a rising market than the Index IQ ETF. The ProShares fund was launched in December 2012, so there’s no track record to speak of. 

And whereas Index IQ actively selects which M&A transactions it seeks to arbitrage, the ProShares fund simply replicates the performance of the S&P Merger Arbitrage Index, which is comprised of a maximum of 40 large and liquid stocks that are active targets in pending merger deals—half of the targeted deals are in the U.S.

It’s best to view merger arb funds as a way to hedge a long-oriented portfolio. In effect these funds should produce greater gains than bonds but without the volatility of stocks. Indeed the S&P Merger Arbitrage Index has returned 4.6 percent on a 3-year annualized basis, which compares quite favorably to bond returns. The 5-year annualized return of 2.9 percent is less impressive.

But ProShares’ Sachs thinks the rising tide of deal making we’re now seeing should help boost results. “As the number of deals increases this approach will yield a rising number of profitable arbitrage opportunities,” he says. “More people will be looking at the merger arb angle as deal-making volume rises.”

Taking Note

While both of these ETFs charge a fairly stiff 0.75% expense ratio, Credit Suisse offers a pair of ETNs that carry a more reasonable 0.55% expense ratio. The Credit Suisse Merger Arbitrage Index ETN (CSMA) is based on a firm-run index that targets announced deals where the acquisition target has a market value of at least $500 million.

The rising tide of deal-making may lead investors to Credit Suisse’s sister fund, the Credit Suisse Leveraged Merger Arbitrage Index ETN (CSMB), which is a “2x” fund, which means it will move at twice the rate of the CSMA ETN.  Credit Suisse uses ETNs instead of ETFs because they’re better at avoiding the tracking error associated with some index-based ETFs.

Given the robust volume of deal making so far this year and what that portends for the rest of 2013, merger arb funds look poised to post solid gains with lower volatility.