"We had the perfect storm last year, and it showed in our results," said Orrico, whose fund invests in as many as 60 transactions at a time.
The Arbitrage Fund climbed 9 percent in 2001 when the S&P 500 fell almost 12 percent and gained 9.3 percent in 2002 when the U.S. benchmark index dropped 22 percent. The fund started trailing in 2003 as equity markets rallied.
Last year, the fund rose 0.6 percent, compared with the S&P 500's 11 percent increase and the average 7.4 percent gain of five mutual funds that focus on mergers and acquisitions, Bloomberg data show. The Pennsylvania Avenue Event-Driven Fund was the top performer, climbing 26 percent.
The largest arbitrage fund, the $1.6 billion Merger Fund, is run by Frederick W. Green and Bonnie Smith and is closed to new investors. The others are the $317 million Gabelli ABC Fund, managed by Mario J. Gabelli; the $285 million Enterprise Mergers & Acquisitions Fund, overseen by Gabelli and Paolo Vicinelli; and the $425,000 Pennsylvania Avenue Fund, managed by Thomas Kirchner.
Hedge funds focusing on merger arbitrage have more than tripled since 1999, according to Chicago-based Hedge Fund Research Inc. About $14.5 billion was invested in merger arbitrage funds at the end of last year, up from $4.3 billion in 1999.
"People take different approaches to risk," Enterprise's Vicinelli said. "One of the questions we put a lot of emphasis on is: 'Who is the buyer?' We would much rather see a big blue-chip company like Procter & Gamble or General Electric."
The Enterprise fund, which devotes a third of its assets to companies the managers single out as potential takeover targets, advanced 6.4 percent last year. The fund had 28 percent of its assets in cash at the end of December, compared with the Arbitrage Fund's 3.5 percent.
Orrico has managed merger arbitrage funds for 10 years, first at Gruss & Co., then at Lindemann Capital Partners in New York. He has overseen the Arbitrage Fund since it opened in September 2000 and holds a degree in finance and international management from Georgetown University.
Johnson & Johnson Inc.'s purchase of Guidant Corp. helped make 2004 the busiest year for mergers and acquisitions since 2000, when stock prices peaked. Orrico first bought shares of Guidant a week after the maker of heart-devices agreed to be acquired by Johnson & Johnson for $25.4 billion. At the same time, Orrico borrowed shares of J&J and sold them as a way to protect the fund from swings in the stock's price.
He plans to sell his stake in both companies, the fund's largest positions, on Dec. 31, once the deal is completed. Until then, Orrico adjusts his holdings in both companies depending on fluctuations in the share prices and as the companies overcome administrative and regulatory hurdles. The stocks accounted for 5.4 percent of the fund's assets at the end of December.
"Our hedging is a day-to-day process," Orrico said. "Sometimes it's more art than science, more instinctual."
Orrico tries to handicap the likelihood that a transaction will be completed before making an investment. He talks to Wall Street analysts and the managements of companies involved as well as to rivals to gauge whether regulators and shareholders will approve a takeover. He limits his investments and sometimes buys options to ensure that if a deal unravels, the fund won't lose more than 1 percent of its net asset value.
"That's the worst-case rule," Orrico said. "We need to understand what's driving these guys to combine and how receptive shareholders are going to be to this deal."