Funds that let investors tap into M&A fever

T-Mobile US Inc. plans to buy Sprint Corp. in a $26 billion deal that is just the most recent round of M&A activity in the U.S. this year. Why are so many companies feeling the urge to merge, and how can investors best take advantage of this global trend?

When companies have lots of cash, they often find other companies that they love very much. The result is either a merger or an acquisition, which can often be cheaper than creating a new division or expanding into a new territory from scratch.

Right now, companies do indeed have a great deal of cash: Nonfinancial companies in the Standard & Poor’s 500 stock index currently have a record $1.6 trillion in cash sitting on their balance sheets, according to S&P Global. Not only do they have cash, they’re starting to use it: Global M&A activity in the first quarter totaled $1.2 trillion, according to Thomson Reuters.

Those cash balances should grow as companies take advantage of tax reform, which lowered the corporate tax rate to 21%. The Tax Cuts and Jobs act would also cut the tax rate companies pay to repatriate currently deferred foreign profits to 15.5% for cash and cash equivalents, and 8% for reinvested foreign earnings.

Some of that new cash will be used for dividends and buybacks, as well as capital expenditures. But a serious chunk of it should also go to mergers and acquisitions.

There are two main ways to capitalize on an M&A boom. The first is through merger arbitrage, which keys off the notion that cash-rich companies rarely spend their money wisely. Typically, the company making the purchase overpays, which means the stock price of the target rises, while the stock price of the acquirer declines.

Merger arbitrage seeks to profit from that tendency by buying the shares of the targe, while simultaneously selling short the shares of the purchaser, to bet on falling prices. The object is to create consistent, low volatility returns that are higher than one could get through relatively safe investments, such as money market funds or bank CDs.

One merger arbitrage fund, The Arbitrage Fund (ARBFX), has gained an average 3.15% a year over the past 15 years, versus the 3.85% return on the Bloomberg Barclays US Aggregate Bond total return index and 2.31% for the average market-neutral fund, according to Morningstar Inc. While the fund’s gains are not exciting, it has delivered its returns with a 3.90 standard deviation, while the typical market neutral’s volatility measure has been 5.16.

An ETF offering, IQ Merger Arbitrage ETF (MNA) offers a similar strategy at a lower price. The ETF charges 0.76% a year — high for an ETF, but lower than the fees on most market-neutral merger arbitrage funds. (The Arbitrage Fund’s retail shares charge 1.51%). IQ Merger Arbitrage is up an average 4.12% over the past five years, versus 1.71% for The Arbitrage Fund.

Another way to invest in the merger boom is through deep value funds, whose fondness for underpriced stocks makes them likely to own acquisition targets. Morningstar lists 161 large-company deep-value funds. Copley Fund (COPLX) is this year’s leader, with a gain of 12.95%. Mount Lucas U.S. Focused Equity Fund Class I (BMLEX) is the runner-up, with a 6.24% gain this year, powered mainly by energy picks.

These funds don’t look for takeover targets, per se: They simply look for many of the same things that takeover artists do. And their strategy doesn’t guarantee that they will own the big deal of the day, or that much of it. The largest holder of Sprint, for example, is large-cap value fund Dodge & Cox Stock, which held 2.52% of the company’s stock. Nevertheless, Sprint makes up just 0.71% of the $69.2 billion fund’s portfolio, according to Morningstar.