Going through the back door for M&A deal profits

Mergers and acquisitions are hot. Corporations flush with cash may not be hiring hordes of workers, but they aren't just buying back shares or increasing dividends, either.

Global merger-and-acquisition volume totaled $2.4 trillion through late August, according to Dealogic. That's a level not seen since the financial crisis.

Controversial tax inversions are a significant part of the recent deal flow, but to an even broader extent, big companies are looking down the market-cap scale and across the globe for growth engines. The U.S. has accounted for nearly half of the merger volume this year, driven mainly by technology and health-care deals.

Merger M&A
Miguel S. Salmeron | Getty Images

For investors—far from the Wall Street boardrooms and corporate law firms where these deals are hammered out—the problem is finding a way to tap into the merger boom. "There isn't a perfect way to play the trend," said Joe "JJ" Kinahan, chief strategist at TD Ameritrade. "It's hard to predict the next takeover target. And deals can be called off, sending a stock down 50 percent."

There is a way to play the M&A craze in one trade, though, without risking it all on any single company and without seeking a huge spike in a single company's shares: Merger arbitrage exchange-traded funds (ETFs).

These ETFs are versions of a popular hedge fund strategy to bet on the stock prices of companies targeted in planned acquisitions once those deals are announced. Merger arbitrage ETFs diversify risk by spreading their bets across deals. The strategy is, in effect, a bet on the gap between the targeted company's stock price after the merger announcement and its price when the deal closes.

A huge M&A market ... for tiny ETFs

IQ Merger Arbitrage ETF, for example, is invested in some of the more high-profile and controversial deals currently in the M&A market. The ETF, which tracks the ETF company's own M&A index, has roughly $62 million invested across roughly 45 global stocks, including the battle between Dollar General and Dollar Tree for Family Dollar Stores, Comcast's closely scrutinized bid for Time Warner Cable, Burger King's deal with Tim Hortons—which has attracted attention related to the tax-inversion issue, and AT&T's planned acquisition of DirecTV.

"Returns are becoming more robust," said Adam Patti, CEO at IndexIQ Advisors. "Cross-border deals are taking a greater piece of the overall merger pie. Larger companies want to play in many different markets."

IQ Merger Arbitrage has $62 million in assets and a 0.76 percent expense ratio, according to Morningstar.

Read MoreInvestors prefer increased dividends in ETFs

ProShares Merger ETF tracks the S&P Merger Arbitrage Index, but it's small: $1.8 million in assets, according to Morningstar, spread among roughly 40 targeted companies. Its expense ratio is 0.75 percent.

Merger arb ETFs typically short equities in some manner while going long on the targeted stocks as a hedge. ProShares Merger ETF also shorts the stock of up to 40 acquiring companies; IQ Merger Arbitrage shorts global equities broadly. Both ETFs also invest in cross-border currency trades.

While investment bankers and C-suite executives may rake in huge sums from deals, forget high returns through merger arbitrage ETFs, though. When used properly, the idea, co-opted from the hedge fund world, is designed as a market hedge to generate returns uncorrelated to the overall direction in equities and bonds.

For example, the S&P 500 had logged an 8.6 percent through the end of August, according to Morningstar, compared to a 3.85 percent return for the IQ Merger Arbitrage ETF.

The returns have been muted during the extended bull market run. The IQ Merger Arbitrage Index, which has been in existence longer than the ETF, had returned 4.22 percent over a five-year time span through Aug. 31, compared to 92.5 percent for the S&P 500.

ProShares Merger ETF had lost close to 2 percent so far this year through Aug. 31.

Read MoreWhat would Bogle and Buffett think of these ETFs?

But Morningstar ETF analyst Robert Goldsborough described these ETFs as offering "bondlike returns" and said as a result it's best to compare returns to three-month T-bills.

The goal is portfolio diversification and volatility reduction, not shoot-the-lights-out returns, said Neena Mishra, director of ETF research for Zacks Investment Research.

David Fabian, a managing partner at FMD Capital Management in Irvine, California, said these ETFs should comprise at most 5 percent of an investor's portfolio. But Fabian thinks investors are better off sticking with sector ETFs—specifically, cash-rich sectors where deal activity is likely to happen, for example, right now in health-care. That's not a market hedge bet, like the merger ETFs, but a straight trade on stock prices going up in a sector based on an expected wave of M&A.

Another way to play M&A

Pharmaceutical giant Merck's recent announcement that it's buying U.S.-based life-science player Sigma-Aldrich is the latest in a long string of 2014 deals.

Fabian is most bullish on biotech ETFs. "Lots of smaller companies get swallowed up in biotech," he said. Biotech ETFs, even after some volatility earlier this year, are still generating 20 percent to 30 percent-plus returns year-to-date

The SPDR S&P Biotech ETF, which has 79 holdings, is one ETF that Fabian is recommending. The California biotech player InterMune, which agreed to be acquired by the pharmaceutical giant Roche Holding, is among the biggest stock bets in that index ETF. XBI has an expense ratio of 0.35 percent.

Fabian also likes the First Trust NYSE Arca Biotechnology Index Fund, which also includes a large position in InterMune, and has an expense ratio of 0.60 percent. "Look for equal-weighted ETFs, where smaller companies will have greater pull," he said," than in larger diversified funds." Equal-weighted ETFs do not tilt their holdings toward the larger, market-cap companies.

Inverse logic

The Treasury's recent crackdown on tax inversions, in which U.S. companies buy foreign companies to reincorporate overseas and lower their tax rates, is putting a wrinkle in merger deal plans.

"Big pharma companies are the most affected," said Stefan Quenneville, a biotechnology analyst at Morningstar, adding, "this is creating negative sentiment within health care." He said the Merck deal would not be affected by the government crackdown on inversions. Biotechnology, which has been on a tear this year, is more immune overall, he said.

Read MoreTax inversion deal collapses: Will others be next?

There are hundreds of small, public biotech stocks, noted Brian Klein, a senior analyst at Stifel, and "the majority of them aren't profitable, so they wouldn't benefit from inversions."

In the end, it's not the bet on how the inversion controversy ends that will most directly influence the right merger-and-acquisition bets. It's the more obvious fact about M&A that makes it a difficult way to invest: Deals are very unpredictable, Fabian said.