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DATE/ AUTHOR None	AUTHORS: Barry Rehfeld

H One Way to Play the Mergers Boom

S1 MERGERS and acquisitions have been booming, and investors looking for a way to profit from them have a simple solution at hand: they can invest in mutual funds that specialize in buying shares of companies that are being acquired.

S2 But don't expect to make a killing.
S3 These funds -- and there are at least five of them -- are generally considered to be having a good year if they double the returns on three-month Treasury bills.
S4 Last year, the five funds returned 10.1 percent, on average, while T-bills averaged less than 5 percent, but still gained far less than the nearly 16 percent return for the Standard & Poor's 500-stock index.
S5 Over five years, the funds' return was 5.5 percent, annualized, compared with 6.2 percent for the S.& P.

S6 Mainly, the funds offer extremely consistent gains from a highly diverse portfolio, and at the end of a year investors almost always have more than they did in January.
S7 Consider the Merger Fund, the oldest and biggest at $1.5 billion.
S8 It has had only one losing year out of 17.
S9 The Gabelli ABC fund, the second-oldest and third-largest with $193 million in assets, is a perfect 13-0.

S10 ''What we do is fairly straightforward,'' said Frederick W. Green, president of the Merger Fund.
S11 ''We're the sleep-well-at-night fund.''

S12 The gains come from buying shares in a company that is being acquired, but for less than the acquirer plans to pay, then cashing out when the deal is done.
S13 Because, as Mr. Green says, 95 percent of the mergers are completed, generally within a matter of months, it's a pretty safe bet that buyers will earn the difference, or spread, between the two prices.

S14 The favorable odds go a long way toward explaining why merger or risk arbitrage, as the strategy is known, produces returns that tend to be lower, on average, than those of other stock investments.

S15 Investors trying to buy the shares after a merger announcement can't expect to get the stock for much less than the acquirer's offer, because the current shareholders can reasonably count on getting that price shortly.
S16 How much less depends on a number of factors for both buyer and seller -- for example, what their money could reliably earn in another investment, like three-month Treasury bills, or the value attached to the 1-in-20 possibility that the deal will fall through (say, over regulatory problems).

S17 When mergers are plentiful, as they are now, fund managers can pick their targets more carefully than usual.
S18 And with interest rates having edged higher, the spreads have widened between the post-announcement market price and the offer price.

S19 At times, some merger funds will short the stock of the acquirer as well as buy shares in the target company.
S20 The tactic is similar to that used by hedge funds engaged in arbitrage, though without black-box secrecy or the risk of leveraging.
S21 The price of the acquirer's shares tends to slip after the offer is made, so shorting those shares is a way to improve returns.

S22 The five-year-old AXA Enterprise Mergers and Acquisitions fund, the second-largest fund with $304 million in assets, adds a much riskier arbitrage strategy to the mix.
S23 One-third of its capital is invested in companies that Mario J. Gabelli, the veteran money manager who oversees the fund along with his namesake ABC fund, regards as having the potential to be acquired.
S24 For example, three companies in which he invests as takeover candidates are U.S. Cellular, Sensient Technologies and Cadbury Schweppes.

S25 Potential takeover targets in general are more speculative investments than the traditional arbitrage plays.
S26 If the main appeal of a company is its takeover potential and no offers materialize, its stock price may fall and give the fund a loss.
S27 On the other hand, if the company is taken over, the fund gets the full measure of the premium the acquirer pays.
S28 Such gambles increase risk, but may also improve total returns dramatically over the standard arbitrage performance -- as was the case in 2006 with AXA Enterprise.

S29 For the year, according to Morningstar, AXA Enterprise gained 15.2 percent, more than three percentage points ahead of Gabelli ABC, the runner-up, at 12 percent.
S30 They were followed by the Merger Fund, at 11 percent; the year-old, $7 million QCM Absolute Return fund, at 7 percent; and the six-year-old, $84 million Arbitrage fund, at 6.1 percent.

S31 But while 2006 was a good year for the funds, not even AXA Enterprise quite caught up with the S.& P. index, which returned 15.8 percent for the year.
S32 Over one-, three- and five-year stretches, the returns of the group averaged several percentage points below those of the S.& P.

S33 Another concern is cost.
S34 Four of the funds have expense ratios that are higher than the mutual fund average of 1.27 percent, according to S.& P. (And Enterprise has a front-end load, or sales charge, of 4.75 percent.)

S35 The exception is Gabelli ABC, whose ratio is half the average.
S36 But its minimum initial investment is $10,000 (though down from $50,000 in 2005), versus $2,000 or $2,500 at the other funds.
S37 And investors can buy it only through Gamco Investors, Gabelli ABC's money management parent.

S38 There are also taxes to consider.
S39 ''These funds deal in short-term trades, so if they make money there are going to be capital gains to pay,'' says Russel Kinnel, director of research at Morningstar.
S40 ''They're better for retirement portfolios.''

S41 Mr. Kinnel also says that these funds' returns may be squeezed over the long run by competition from hedge funds.
S42 As the number of hedge funds increases and their war chests grow, more dollars are likely to be chasing a shrinking number of deals, since merger mania can't be expected to continue forever.
S43 The growth in competition may be a compliment to the arbitrage strategy, but spreads would be likely to narrow, thus hurting the performance of all arbitrage funds.

S44 Zoë Brunson, director of portfolio services at S.& P., suggests that if investors are convinced that the good times for mergers will continue, and want to profit directly, they have alternatives to arbitrage funds.
S45 They might try small-cap funds, she said.

S46 ''You get your exposure to mergers and acquisitions because that's where a lot of them are,'' she said.
S47 ''You may take on more risk, but there's greater upside potential.Not that they're better.
S48 It's just a matter of what you have an appetite for.''

S49 MUTUAL FUNDS REPORT

