How the little guy can profit from merger mania

On April 8, Royal Dutch Shell announced that it would buy BG Group, a British oil and gas company. Many energy-sector watchers were excited about the deal—it's the oil and gas industry's largest transaction in about a decade—but plenty of investors were, too. Especially ones who like making money off freshly announced mergers.

Barrels are filled with oil at a Royal Dutch Shell lubricants blending plant in Torzhok, Russia.
Andrey Rudakov | Bloomberg | Getty Images
Barrels are filled with oil at a Royal Dutch Shell lubricants blending plant in Torzhok, Russia.

In March, there were about $5.8 billion in total net assets in "merger arbitrage" mutual funds and ETFs. These are investments that take advantage of the spread between the post-merger price and the eventual sale price. Typically, when a merger is announced, the stock price of the takeover target jumps dramatically, but it doesn't usually hit the sale price until right before the transaction is complete.

Merger arbitrage managers typically buy stocks of takeover companies after that initial pop and then sell a day or two before the sale is final. (They sell after the sale is complete, because, in many cases, the stock of the target company can't be sold after the deal is done.) Money is made on the spread between the post-announcement stock price and the final sale price.

Read MoreThe cash cows of equity crowdfunding are ...

For instance, the Shell and BG Group deal is worth $70 billion, or $20 a share. BG Group's stock is currently trading at about $18. As the deal gets closer to completion, the stock price should inch higher to $20, eventually giving investors a 10 percent return.

"We would certainly look at that deal," said Roy Behren, a portfolio manager with Westchester Capital Funds, a Valhalla, New York-based company that runs a merger arbitrage fund. "It fits the profile of the kind of thing we'd invest in."

More mergers activity

Some merger arbitrage securities are seeing solid inflows this year, in part because M&A activity is so strong. In March 2014 the IQ Merger Arbitrage ETF, a fund that invests in global companies that have announced a takeover, brought in $2.7 million. This past March it took in $10 million in assets.

According to an April Ernst & Young report, 56 percent of global companies plan on acquiring a business over the next 12 months. Global deal value is already up 13 percent year-over-year, while the number of deals in the current pipeline is up 19 percent from this time last year.

Naturally, the more deals that happen, the better it is for merger-focused managers, as they'll have more investment options to choose from.

Read MoreTrading the media merger

"You definitely need M&A activity in order for this strategy to work," said Stephen Horan, the CFA Institute's managing director and education co-lead. "That's why people are talking about this more today."

It's also likely that this activity will continue, said Adam Patti, CEO of IndexIQ, the company that developed the IQ Merger Arbitrage ETF.

Read MoreWant a stock windfall? Bet on these big brands

"We're in the early stages of a pretty robust deal environment that will go on for several years, assuming that there's no calamity in the markets," he said. "Interest rates will remain low for quite some time, and companies want to put their cash to work."

Going short and long

People usually make money off the takeover target, which sees its stock price rise far more than the buyer's stock after an announcement, but there's more to this strategy than just purchasing the selling company's stock.

In a stock-for-stock deal, investors have to account for market risk. You don't know exactly where that stock price will end up. So the investor will buy the stock of the target company while shorting the stock of the acquiring company.

If a deal goes through, it's unlikely the short will make the investor any money, but if it goes belly up or closes at a lower price than expected, then it can act as a hedge. In a bust situation, the share price of the target company will fall, but usually the price of the buyer drops, too. The short position will help cover these equity losses.

The merger arbitrage ETF doesn't short a business specifically—it doesn't want to take any company-specific risk—but rather, it buys a short on a sector index or a broader index, like the S&P 500, said Patti.

Read MoreThese hot funds are leaving the S&P in the dust

In an all-cash deal, an investor wouldn't short the buyer's business, as the target price is more certain. They'd just go long on the target stock and hope the deal goes through.

"In this case, the term merger arbitrage is actually a misnomer," said Horan. "There's really no arbitrage. You are speculating the deal will go through, or at least you are implicitly placing a higher probability on it than the market."

"Investors should be aware that this is a niche strategy, and there are only a handful of funds available to purchase."

A lot of people like this strategy because returns tend to be uncorrelated to the stock market and volatility is fairly low. Michael Shannon, the co-manager on Westchester's Merger Fund, said that the S&P 500's annualized standard deviation is around 18 percent, while his merger fund is around 4 percent standard deviation. The IQ Merger Arbitrage ETF's standard deviation is about 5 percent since the fund's inception.

The reason why this strategy causes investors less day-to-day stress is that returns are fairly predictable. About 90 percent of all mergers close, said Behren, so if it's expected that a company will get bought at $20 a share, then it usually does. Patti adds that the average return on an individual stock is about 3.5 percent over about 120 days—the average time it takes for a deal to close—which would be about 10.5 percent annualized.

Despite that certainty, this strategy would be risky for the average investor to do by him- or herself. Since it usually takes at least three months for a deal to close, you won't make any money during that time. If it falls apart, then the loss could be huge.

Read MoreThese companies are the real earnings bellwethers

Using BG Group as an example, on the day of the announcement, the company's stock price shot up by about 38 percent. While investors could make about $2 a share if the deal happens, if it doesn't, then the stock will likely fall back to its pre-announcement price—a much steeper dive than gain.

Even if 90 percent of acquisitions close, a few bad deals can sink a merger arbitrage portfolio, said Behren. He needs almost 99 percent of the deals in his portfolio to come to completion for his fund to make money.

Deal or no deal

Investors should be aware that this is a niche strategy, and there are only a handful of funds available to purchase. The three securities with the largest total assets include Westchester's Merger Fund, which had $5.3 billion in total assets in March 2015, the Touchstone Merger Arbitrage Fund, which had about $300 million in total assets last month and the IQ Merger Arbitrage ETF, which had $112 million in assets in March.

Like most non-traditional strategies, investors should only put about 5 percent to 10 percent of their assets in this type of investment. It's also difficult for an investor to do it alone. While you can buy one merger arbitrage opportunity, if it doesn't turn out as planned, you can lose a lot of money. ETFs and funds hold a number of stocks, so if one deal sours, it won't sink a portfolio.

It's also difficult, and risky, to predict a merger, which is why arbitrage funds only act after an announcement. Managers have to determine whether or not a deal will go through. To do that, they take a look at the premium that the buyer is paying. The larger it is, the better chance of it happening, said Horan. They also pay attention to the ownership structure. The less concentrated it is, the less likely someone will lobby against the deal.

Read MoreMarket got you worried? Try hedging against risk

The biggest risk to a takeover is usually regulatory, said Behren. There could be antitrust issues, approvals from the Department of Justice or the Federal Communications Commission or sign-offs from regulatory bodies in other countries. There's also voting risk—will shareholders approve the merger—and there could be a risk to future earnings, too.

"You have to quantify all of those risks," said Behren. "Then if it's still attractive, we'll look at it."

—By Brian Borzykowski, special to CNBC.com