Last year was a bust for mergers and acquisition (M&A) activity; credit markets froze and buyers just couldn’t obtain financing. Deal activity was off by as much as 40 percent in the US, while worldwide more than 1,300 transactions valued at more than $911 billion fell through.

In that type of environment, it’s difficult to believe that two mutual funds focused on arbitrage, essentially trimming the spreads on M&A deals, could actually turn in a solid performance. But the Merger (MERFX) and Arbitrage R (ARBFX) funds did just that, giving up just 2.3 percent and 0.6 percent in total returns last year. And to top it all off, they did it with less volatility than the S&P 500; Merger posted an average beta of just 0.2, and Arbitrage a slightly higher 0.6.

How is that possible?

While last year was definitely brutal for investment bankers and private equity firms, they’re just two players in a broad space and are primarily involved in larger deals. But beyond the reach of the media, smaller companies continued to buy up competitors and take themselves private. And from the perspective of M&A funds, the size of the company doesn’t particularly matter in most respects because they’re playing off pricing inefficiencies in the market.

Essentially, the basic strategy for both funds involves watching the news. Each has teams of analysts that dig into the details of transactions to identify those most likely to be completed and which offer the best risk reward profiles. They’re not trying to identify and invest in potential takeover candidates; the deals must be publicly announced.

They turn a profit by playing the spread between the current market price and the announced takeout offer. This opportunity arises because the broader markets tend to price in risk that the deal won’t get done. But several thousand deals have been arbitraged between the two funds, both of which employ teams of analysts, attorneys and industry experts, giving them a distinct advantage in identifying deals that will close.

Forecasts for M&A activity in 2009 remain weak. But the odds remain that we’ll continue to see ongoing acquisitions among smaller financials and by larger, better capitalized companies. Currently more than 150 M&A transactions have been announced for 2009, roughly 80 of which close in the first six months of the year. And more are likely.

These funds don’t make their money on a deal, just the spreads, so it doesn’t matter if overall volume declines, though it may limit options. And both funds operate on an international scale, so they’re not locked in to investing in US companies.

Both funds employ the same basic strategies depending on the type of transaction. In buyouts involving only stock, the funds will take long positions in the acquisition target and short positions in the acquirer. That captures the full buyout price of the target while profiting from the accompanying dip in the acquirer’s share price. In cash-only transactions, the funds take a long position in the target.

Both funds can also employ leverage and use derivatives for hedging purposes or as a more cost-efficient method of playing some foreign transactions.

On the surface, both funds deploy similar strategies. The primary difference is in the size of the companies in which the funds can invest. With Merger holding almost $1.3 billion, it tends to focus on deals where the target company is valued at a market capitalization of at least $300 million. Arbitrage, weighing in at a sprightly $230 million, can tap into smaller companies without markedly moving prices. That was a key factor in the latter’s superior performance.

Merger tends to hold a more diversified portfolio than Arbitrage, with no single industry group representing more than 25 percent of net assets. Its average position also rarely exceeds ten percent of assets. Arbitrage tends to be slightly more concentrated, which is largely a function of its smaller asset base.

One advantage of the Merger fund is that 100 percent of the advisors’ pension and profit sharing plans are invested in the fund. Managers and employees also invest significant portions of their personal assets into the fund.

Overall, both funds would make excellent holdings, providing stock exposure with low correlations to broad indexes, as well as a hedge against adverse market conditions. They shouldn’t be overweighted; rather, they should fit in the “special situations” portion of your portfolio.