ROY BEHREN
Merger Fund

Age: 49

Credentials: BS in economics, UPenn's Wharton School; JD, University of Miami Law School; LLM in corporate law, NYU School of Law

Experience: Co-portfolio manager, Merger Fund (2007- present); chief compliance officer, Westchester Capital Mgmt. (1994-present); Redback Networks (2004-2007); enforcement attorney, SEC (1987-1994)

Ticker: MERFX

Inception of fund: 1989

Style: Long-short

Assets under management: $2.1 billion

Three- and five-year performance as of Dec. 4, 2009: 3.1% and 4.29%

Expense ratio: 1.47 %

Front load: None

Minimum investment: $2,000

Alpha: 4.0% vs. Merrill Lynch USD Libor 3-month CM

In the shadow of the worst stock market most advisors have seen in their careers, many are reexamining ways they might have shielded their clients' portfolios. Diversification didn't really protect portfolios the way people assumed it would.

But hedging strategies are different:They are not correlated with the market. In 2008, some hedging strategies failed to produce positive returns, but their performance did beat traditional asset classes. As a result, advisors view hedging strategies as a way to provide ballast to a portfolio in severe storms. Seventy-six long-short funds were opened in 2009, according to Morningstar.

One of the oldest hedging mutual funds is the Merger Fund, launched in 1989 by Fred Green of Westchester Capital Management in Valhalla, N.Y. The fund uses a merger arbitrage strategy. In 2008, the fund declined only 2.3%, leaving both the average stock mutual fund and the S&P 500 in its dust. "The transactions we invest in are insulated from the market because they're dependent on deal completion rather than stock appreciation," says Roy Behren, who, along with Green and Michael Shannon, manages the $2.1 billion fund.

ITS OWN BEAT

The Merger Fund doesn't follow the fortunes of the stock market in either good or bad years. As long as one company still wants to buy another, the fund can continue clocking high single-digit or low double-digit gains, year after year.

Not surprisingly, the Merger Fund has not kept pace with the market's rebound in 2009. But in the long run, the fund has performed admirably. Over the past five years, it is up 4.3% through Dec. 1, besting 79% of its long-short peers, according to Morningstar. In the past 10 years, it's up an annualized 4.6% and in its category's top 28%. That beats the S&P 500 by less than one percentage point over a five-year period and lags by just a fraction of a percent over the past 10 years, with a lot less volatility.

Nonetheless, the rising stock market has helped the Merger Fund by bringing an increased supply of mergers and acquisitions for the team to consider. During the early months of 2009, it seemed that conditions were ripe for a merger frenzy-low equity valuations and potential acquirers with sizable cash kitties. But it turned out that target firms weren't interested in selling at such low prices and were holding out for the rebound before inking any deals.

"On a dollar basis, there were more terminated transactions than completed ones," Shannon says. "Leveraged buyout and private equity firms that relied on borrowing weren't able to get the financing because of the credit crunch."

But recently, deal flow has started to rise, says MergerMarket, which monitors corporate mergers. Through the end of November, deal flow in the fourth quarter looked like it was on track to be the strongest all year.

SNIFFING OUT MERGERS

The Merger managers wait until a deal is announced before taking action. "We do not buy on rumor," Behren explains. When an announcement is made, however, the price of the target company normally shoots up. But it does not rise as high as the price that the acquiring firm plans to pay once the deal closes. For example, Company A plans to buy Company B at $20 a share, to be paid in cash. The stock may rise to $18 a share once the deal is announced, taking into account that the deal must still clear regulatory hurdles and shareholder approval.

If the managers feel confident the deal will close within a reasonable amount of time, Merger buys shares of Company B. The $2 spread is ample reward for an investment lasting just a few months.

INTENSE RESEARCH

The portfolio holds only 20 to 60 names, although at any given time there are 100 to 175 pending mergers. The managers are wary of deals that might take a long time to close or be unduly complicated. "all these investments need to be attractive on a risk-adjusted basis, not just an aggregate-return basis," Behren says.