Fund aims to stand out in sideways or down markets

For retail-class investors with an appetite for alternative strategies, there aren’t many options more true to the methodologies applied by hedge fund managers than the Arbitrage Fund (ARBFX).
This isn’t to suggest that the registered mutual fund is for everyone. If that were the case, the fund’s assets wouldn’t be stalled in the $165 million range after more than six years in business.
The fund, managed by John Orrico through his New York investment boutique, Water Island Capital LLC, offers exposure to a pure merger arbitrage strategy.
What distinguishes this mutual fund from a hedge fund that practices the same strategy is the absence of leverage and performance-related fees.
Also, as with most hedge funds, the strategy is less about knocking the cover off the ball than it is about taking advantage of what the market offers.
With a target annual return rate of about two times short-term interest rates, the fund naturally has emerged as a nifty fixed-income alternative.
“We don’t stand out in bull market environments, but we think we demonstrate best during sideways or down markets,” Mr. Orrico said. “Investors should be able to expect this fund to be up about 1% each month, regardless of what the Dow [Jones Industrial Average] is doing.”
In order to maintain a balanced exposure to a range of deals, Mr. Orrico and his team constantly evaluate the flow of deals of all shapes and sizes in search of the next opportunity.
“Our job is to look at thousands of deals and find the top 50 from a risk-reward standpoint,” he said.
While the analysis of every deal can be as unique as the deal itself, the goal is to capture the spread in each transaction, while limiting the downside exposure in the event that a deal doesn’t close or takes longer than anticipated.
When a deal collapses — as was the case in the final week of March — the portfolio can temporarily be derailed.
In that case, Mr. Orrico had allocated 1% of the fund’s assets to shares of Electronic Clearing House Inc. (ECHO), a Camarillo, Calif.-based company that agreed in December to be acquired in an all-cash deal for $18.50 a share, or about $150 million.
At the time of the announcement that the company was being acquired by Mountain View, Calif.-based Intuit Inc. (INTU), Electronic Clearing shares traded at about $12. After doing his research, Mr. Orrico started buying in at about $17 a share.
But just prior to the deal’s scheduled close late last month, Intuit tried to renegotiate its offer, based on a one-time fine Electronic Clearing had to pay to the federal government.
From there, the negotiations broke down, the deal collapsed, and Mr. Orrico was left holding shares of Electronic Clearing that had dropped 30% from their pre-announcement range.
That single bad deal, which led to the fund’s only negative performance week of the year, underscores the importance of diversity within the portfolio, he said.
“One bad deal can take down the gains from four or five good deals,” Mr. Orrico said.
With that in mind, he manages the fund for a broad exposure to cash and stock deals, including a current 20% allocation to international deals — one of the fastest-growing areas of the merger arbitrage strategy.
High turnover
In deals involving stock, Mr. Orrico typically buys shares from both the seller and the buyer but uses derivatives or short-selling strategies to manage the risks.
One example is the February announcement by Birmingham, Ala.-based Vulcan Materials
Co. (VMC) that it will acquire
Jacksonville-based Florida Rock Industries Inc. (FRK) in a stock deal.
Mr. Orrico, who added long exposure to Florida Rock and short-sold Vulcan, expects to net an annualized gain of about 13% when the deal closes in September.
Because deals tend to take an average of about four months to close, the portfolio does generate some whopping annual turnover rates — nearly 400% last year.
Of the 50 deals to which the fund is currently exposed, slightly more than half are cash deals, and about 40% of all the deals have a corresponding short-side hedge.
Year-to-date through Thursday, the fund had gained 2.6%, compared with a 2.4% average return for funds in the long-short category as tracked by Morningstar Inc. in Chicago.