It’s been a choppy year for investors. The stock market has seen multiple rounds of volatility, with the S&P 500 down 1.3% year to date. Bonds haven’t been a shelter. The Bloomberg Barclays US Aggregate Bond Index has slipped 1% since the beginning of the year.
One type of fund, however, has been relatively unscathed by 2018’s turmoil. Westchester Capital’s Merger Fund Investor Class (MERFX), with $2.6 billion under management, has surged 7.3% this year so far, and is on pace for its best year since 2009.
That’s exactly what the fund was supposed to do: offer steady returns regardless what the stock and bond markets do.
How funds bet on mergers
As its name suggests, the Merger Fund pursues a strategy called “merger arbitrage”—buying shares of a target company in a publicly announced acquisition, and shorting stocks of the acquiring company.
If the deal goes through, shares of the target company will be taken over at the agreed-upon price, which is typically higher than the market price, even after an expected boost after the deal announcement. Shares of the acquiring company, on the other hand, sometimes fall after the deal is completed if investors think it overpaid. Merger arbitrage traders try to reap gains from that price spread in between.
The risk, however, lurks in the chance that the deal falls apart, the target company’s stock drops, and the acquirer’s stock rises. That’s why target stocks typically trade at discounts to the acquiring price until the deal is actually closed: The market is skeptical of the transaction…
…“Where you can really add value to the strategy is to avoid the blowups,” said Michael McLochlin, a Highland Capital portfolio manager. “Over time, over 90% of the deals close, so it’s our job to decide which deals are going to break and avoid those.” Highland runs a smaller merger-arbitrage fund, the Highland Merger Arbitrage (HMEAX), which has about $39 million under management, and has generated a 5.8% return this year…
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