Mergers Mean Quick Gains for Funds

By Tim Paradis
Associated Press
Sunday, November 26, 2006

NEW YORK -- Investors observing the seemingly uninterrupted parade of corporate buyout announcements might wonder how much the deals and the attendant rise in stock prices will boost returns in their mutual funds. The answer depends on the type of funds they own.

Acquisition announcements often inspire investor confidence because the deals generally reflect a sense that the stock market offers bargains on desirable businesses. That notion can send stocks up in general, which benefits many mutual funds. And while the many merger announcements have prompted questions about whether the market is overvaluing some properties, mutual funds returns for the year are likely to get a boost from all the dealmaking.

One way investors can benefit from an acquisition is if a fund they own holds shares in a company being acquired. The fund's return can grow from the jump in a stock that often accompanies a buyout announcement. Shares of the company doing the acquiring typically fall, though generally only temporarily, as investors tend to frown upon the risk those companies are taking.

For Barry R. James, a portfolio manager at James Investment Research and president of the James Advantage Funds, the benefits of the buyouts are apparent, though he is quick to note potential pitfalls. The James Small Cap Fund, which has assets of $266 million and is up 13.5 percent this year, has advanced as five of the companies whose stock the fund holds were acquired in the past couple of months.

"Companies are awash in cash and they're just scratching their heads as to what do," James said of the recent flurry of deals. But he noted that even funds with narrow investment parameters can stray from a disciplined investing strategy and put returns at risk if they focus too much on anticipating the next acquisition target.

"We hope all our companies are bought out," he said. "We don't mind that at all but we're not trying to target ones that are going to be purchased."

The inherent diversity of a mutual fund, however, can limit the degree to which a jump in the price of a single stock can help the fund's return. The James funds' shares in companies that are being acquired generally rise 25 percent to 33 percent, but with positions of generally 2 percent to 4 percent, the overall effect on a fund's return is limited, James said.

Other funds seek to profit by buying shares of a company being acquired and, in a tactic known as shorting, bet that the stock price of the acquiring company will fall. Such arbitrage merger funds generally show little correlation to the overall direction of the stock market and instead benefit from an increase in acquisitions simply because that means there are more deals from which to choose.

John S. Orrico, who runs the Arbitrage Fund, said that as the world's economies grow, the possibilities increase for funds that capitalize on the spreads between stock prices and acquisition prices.

"We can cherry-pick through deals from across the globe," Orrico said. "Globalization is going to continue to be the fuel that feeds consolidation."

The Arbitrage Fund has assets of $173 million and a return this year of 5.4 percent. While the returns haven't matched those of other funds that have benefited from surging stock prices, he noted that the fund has gained during down years in the stock market.

Orrico's fund focuses on finding deals that are most likely to close and have the least shareholder opposition, financing difficulties and antitrust concerns. In doing so, the funds are less likely to bet on a deal that ultimately falls apart.

"Our approach is capital preservation while generating a return that exceeds the fixed income markets," Orrico said.

While many types of mutual funds can benefit from increased acquisition activity, the recently announced mergers haven't been concentrated in one sector, making it difficult to pinpoint what the next takeover target might be, said Todd Trubey, an analyst at Morningstar, which tracks funds.

In any case, funds that buy stock in a company shortly before it is acquired can incur short-term capital gains taxes. Still, if the stock price rises enough, the deal could ultimately still prove beneficial for a fund's returns, Trubey said.

While mutual fund holders might welcome an increase in merger activity, there is a risk that buyout prices could become inflated and cause other stock prices to move too high.

"There's a lot of speculation driving share prices higher and people are looking at [buyout] valuations and applying those to companies that are not in deals," Trubey said. "That's a risky business."

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