This Won't Deliver 50% Buyout Gains

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With a number of high profile buyouts hitting the headlines lately, you might want to get in on the action -- and the potentially huge profits that come from buyouts. But even though the long slump in merger and acquisition activity appears to be ending, make sure you understand exactly what you're getting into before you jump on investments that are targeted toward people interested in mergers.

Big payouts for some, little ones for others
When M&A activity jumps, investors start to get greedy, and for a very good reason: The short-term profits involved in a buyout can make up for years of subpar returns, especially with the long-term downtrend that stock market investors have had to live with since late 2007. When BHP Billiton (NYSE: BHP  ) announced its bid for PotashCorp (NYSE: POT  ) , PotashCorp stock jumped more than 25%. McAfee (NYSE: MFE  ) shareholders got a better than 50% boost, thanks to Intel's (Nasdaq: INTC  ) unexpected buyout of the computer security company.

Clearly, if you can anticipate that a company is going to become the target of a buyout, you can make huge amounts of money. An ETF with such a strategy sounds like it could be a good investment if it were successful in finding those companies before mergers were announced.

A completely different strategy
But that's not the strategy that the IQ Merger Arbitrage ETF (MNA) follows. Rather than trying to guess which companies will become future targets of M&A activity, this ETF instead waits for companies to announce plans to partner up with each other. Only then does the ETF buy shares of the target company -- usually well after the stock has enjoyed a huge run upward.

So when you take a look at what an investment in this ETF will give you, you won't see PotashCorp or McAfee on the list. What you will see are stocks that have had definitive deals on the table for quite a while. For instance, Novell (Nasdaq: NOVL  ) received an unsolicited bid from hedge fund Elliott Associates back in March. Although the company rejected the bid, the stock has continued to trade near the bid price, which is much higher than where the stock traded before. Similarly, the fund owns shares of Qwest (NYSE: Q  ) in light of its being bought out by CenturyLink (NYSE: CTL  ) for $10.6 billion in stock.

Has it worked?
What the ETF is trying to do is to reap gains when mergers are completed. Before a cash deal closes, shares of the target company usually trade a few percentage points below the buyout price, reflecting the possibility that the deal won't happen and the stock price will return to its lower, pre-announcement price. As long as everything goes well, the ETF will pocket that difference as profit.

So far, the strategy has produced modest gains. Since its inception in November 2009, the ETF is up 1.7%, versus a 2% decline for the benchmark MSCI World Stock Index.

Despite these market-beating results, however, you should understand that the potential for profit is less than you might think. On all-cash deals, the gains are limited to whatever discount the market assigns to the target's stock price. On stock deals, the price can fluctuate more; unlike some true arbitrage funds, this ETF doesn't hedge by short-selling shares of the acquiring company, so investors' returns are dependent on the acquirer's stock performance.

Don't get confused
With so many new ETFs looking to capitalize on niche markets, you'll often find funds that appear on their face to do exactly what you're looking to do with your investments. Once you look more closely, though, you may find that despite a catchy name, an ETF isn't following the same strategy you would if you were investing on your own. There may be benefits to owning a fund like the IQ Merger Arbitrage ETF, but if you're looking for the big first-day gains that M&A targets see in their stock price, it can't deliver the goods.

Warren Buffett and Peter Lynch were great investors, but they didn't share all their secrets. Let Anand Chokkavelu give you the inside scoop to market-crushing performance.

Fool contributor Dan Caplinger scours the world of ETFs looking for hidden treasure. He doesn't own shares of the companies mentioned above. The Fool owns shares of and has written puts on Intel, which is a Motley Fool Inside Value selection. Motley Fool Options has recommended buying calls on Intel. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy rejected a Goldman Sachs buyout bid and expects to be on its own for a good long time.

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