Some funds profit from acquisitions in any market

Consider funds that trade stocks of companies about to be acquired, and try to exploit price differences between the time a deal is announced and when it closes. The two best-known offerings in this niche, the Arbitrage Fund and the Merger Fund, have rewarded investors with positive returns even while stocks have been mostly down since the market peaked in late 2007.

Arbitrage has posted an average annualized return of 5 percent over the past three years, while Merger averaged 2.9 percent.

In that span, midcap growth funds lost an average 5.8 percent per year, according to Morningstar. In addition to trouncing the category, the two funds avoided the broader market’s sharp ups and downs. When the S&P 500 slid 37 percent in 2008, Arbitrage lost 1 percent, and Merger slipped 2 percent.

The protection means merger arb funds could be a good option for a small piece of an investor’s portfolio, probably no more than 5 percent. And these days, with companies holding plenty of cash, opportunities for the funds could expand.

“They can be a good portfolio diversifier,’’ says Nadia Papagiannis, a Morningstar analyst.

The funds smooth out returns because they don’t tend to move in step with stocks. Regardless of what the broader market does, the stock of a company that’s about to be acquired generally rises if the deal stays on track.

A buyer offers a premium to acquire the smaller company’s shares. Once news of a deal surfaces, the targeted company’s stock typically trades at a slightly lower price than what the acquirer is offering. This price gap is the merger arb investor’s sweet spot.

It’s where money can be made, reflecting uncertainty whether a deal can be consummated. Plenty can go wrong. Shareholders or regulators might not approve the transaction, financing might fall through, or a sudden turn in the market might cause the acquirer to back out.

Merger arb fund managers assess pending deals for those mostly likely to close, and snap up shares of soon-to-be-acquired companies that appear to be cheaply priced.

The chances of walking away with a profit after a deal closes improve the more pending transactions there are to choose from, and the fewer rival investors there are bidding up stock prices. Merger arb fund managers compete against hedge funds, where the strategy is more common.

Lately, opportunities have been mixed. Many hedge funds went under or have scaled back their use of the strategy.

At the same time, there have been fewer deals lately.

Yet the pace of deals and opportunities for merger arb funds could pick up sharply if the economic recovery regains momentum. That’s because many companies are sitting on cash hoards built up during the recession.

Once confidence returns, expect those companies to dip into cash and make deals for smaller companies at a faster clip.

Even though M&A remains subdued, there’s plenty of opportunity. Amid recent strong performance, the decade-old Arbitrage fund has swelled to $1.5 billion, about triple the figure a year ago. With all the money flowing in, the fund closed to most new investors last month.

The $3.3 billion Merger fund recently said it had 61 arbitrage investments, a near-record since its 1989 launch. Since then, the fund has had just two down years, and returned more than 7 percent a year, on average.

Three other funds that are less well-known than Merger and Arbitrage also heavily rely on merger arb strategies: Gabelli ABC, Quaker Event Arbitrage, and AQR Diversified Arbitrage.

Investors will want to consider a few things before getting in:

Tax hit: These funds are trade-happy. The behavior is more likely to trigger taxable capital gains than buy-and-hold investing. These funds are best held in tax-deferred retirement accounts, like IRAs or 401(k)s.

Market risks: In down markets, the funds can still get hit. Pending acquisitions often fall apart or are renegotiated, which can stick the funds with losses. And the funds tend to lag when stocks sharply rebound.