Should You Invest in 'The Poor Man's Hedge Fund'?

Date: Monday, April 27, 2009
Author: WSJ

If you'd invested $10,000 in a stock market index fund 10 years ago and left it alone, you'd have about $8,300 today.

But if you'd invested that money instead in the Merger Fund, a small, little-known mutual fund that bets on takeover deals, you'd have about $16,700.

And you'd have skipped a lot of sleepless nights, too. The fund's ride was a lot smoother than Wall Street's. And last year, when the rest of the world collapsed, it fell just 2%.

"It's the poor man's hedge fund," says Leslie Beck, a Palo Alto, Calif. financial planner who has recommended the fund to clients. "The minimum investment is only $2,000. I think they do a good job."

Of course, as everyone now knows, past performance is no guarantee for the future. Investors should be way of jumping on bandwagons in search of the holy grail of mutual funds. There's simply no such thing. And lots of things could trip up a specialist fund like this, especially in the risky world of merger arbitrage. Investors would be wise to limit any stake to maybe 5% of their portfolio.

Yet this fund is an instructive case study right now. Why? Because most people aren't really diversified – as they found out last year. Large Cap Value, Small Cap Blend, Small Cap Growth: These "styles" are just marketing gimmicks. They're all doing basically the same thing. And they all sank together.

If you really want to diversify, you need to spread your money across a variety of funds investing in different asset classes, managers and strategies, from bonds to absolute return strategies to, say, precious metals or covered call funds. The Merger Fund is completely specialized, and that's the appeal of the thing.

"We're all merger arbitrage," says manager Roy Behrens. "That's all we do here."

That means they try to profit from shares involved in takeover deals. After all, deals are complex: Regulators can block them, boards and shareholders can revolt, rivals can jump into the fray. Merger arbitrage specialists comb the possibilities and the share prices for opportunities.

It takes a lot of homework and experience to see what others have missed. Mr. Behrens is a former Securities & Exchange Commission lawyer. Mr. Shannon is a former merger specialist at J.P. Morgan. They've been co-managing the fund since the early 1990s. The founder, Fred Green, is now president. To study deals they visit companies and talk to top management. And they hire relevant experts, from industry consultants to law firms, to try to understand everything from the legal fine print to the industry big picture.

That helped them make about $45 million from Dow Chemical's recent takeover of rival chemical firm Rohm & Haas. Rohm stock collapsed during the financial crisis. Many investors panicked that Dow would have to walk away. But Mr. Behrens and Mr. Shannon had studied the deal in detail, including the legal agreements. They bet the deal would go through, and it did.

As they often buy the shares of one company in a deal and then bet against or "short" another, the fund is often hedged against market moves as well. "Our goal is to provide positive risk-adjusted returns in any market," says Mr. Behrens. "We should be non-correlated with the equity markets."

The biggest risk is execution: Merger arbs who bet the wrong way lose money. And if deals vanish completely the fund would end up becalmed. But there's no sign of that happening at the moment. Indeed the poor man's hedge fund has kept going while so many of the rich man's funds have blown up. And the Merger Fund typically has its portfolios to 45 to 65 different positions, so investors won't get blown away if one of them collapses.

The Merger Fund is a no-load $1.5 billion fund with an OK 1.4% expense ratio. It has over 100,000 private investors.

In the 20 years since the fund was launched, shareholders have made about 7.5% a year on average. That's a whisker ahead of the Standard & Poor's 500 index. But, more importantly, it has followed a very different path.

Write to Brett Arends at brett.arends@wsj.com