Performance Summary

Hedge funds had a spectacular run in September, reflecting the significant boost to market activity from a sluggish August. Most Eurekahedge regional hedge fund indices were up on the right side of 3% for the month, as is evident from the graph below. Even the under-performing region, North America, registered a spike in its return gradient, rising 1.27% to August's 0.56%.

The key events dominating the month's market scene were 1) the Federal reserve's hiking of its funds rate by 25 basis points to 3.75%, accompanied by feelers about further hikes in the near future to stem inflationary fears; and 2) the ravaging effects of hurricane Rita on key oil refining and production facilities in the Gulf region of the US, not to mention its timing (in the wake of Katrina, as also right before the energy-demand-heavy winter months). Their impact on the US bond and commodity markets, respectively, is not surprising in hindsight. More region-specific repercussions of these events are discussed under the relevant sections elsewhere in this write-up.

September's performance trends were similar to, if more pronounced than, those seen in August. For instance, Japan and Latin America retained their positions as key-performing investment regions, and market sentiment there continues to be positive and strong. Furthermore, Europe, Japan and Emerging markets continued to be resilient to energy-related events in the US. Also, oil and energy-related stocks continued to post healthy increases in economies like Brazil and Russia.

Moving on to some of the notable dissimilarities between monthly trends in August and September, global bond markets witnessed a reversal of the rally in prices seen in August, as a fallout of the Federal Reserve's rate hikes. Bond yields went back to pre-August levels. The month also saw high volatility in the global energy markets, in place of the price rally of the past few months. Fears over the effect of the hurricanes on US economic growth helped push the prices down, with price elasticity of demand for oil also finally kicking in.

The stellar performance of hedge funds in September was primarily driven by booming equity markets across the board, certainly helped by movements in the bond markets. Naturally, equity long/short funds registered fabulous gains almost unanimously across all regions. Also, the drop in bond prices contributed to the under-performance of the related hedge fund strategies such as relative value and convertible arbitrage, in some of the regions. High volatility in the commodity markets had a similar negative impact on the performance of CTA/managed futures funds, in other regions.

North America
Europe
Japan
Asia ex-Japan
Latin America

North America

Market Round-up

In the aftermath of two back-to-back hurricanes that hit the Gulf region in the US and disrupted oil production and refining capabilities, commodity prices shot up but the equity markets seem to be showing a certain resilience. The latter registered marginal gains in September, with the S&P 500 index up 0.69% and the NASDAQ Composite Index down 0.02%. While the Federal Reserve's interest rate hike could not have helped, the markets' belief that the hike may be placed on hold as also the stimulatory effects of the financial aid that would flow into the region, assisted the equity markets on their way up.

The US Treasury markets on the other hand, experienced a reversal of the rally seen in August, following hawkish comments from officials of the Federal Reserve. Yields are back up at end-July levels – 10-year yields rose to 4.32%, up from 4.02%; 5-year yields rose from 3.87% to 4.19%. Despite the higher interest rate environment, the trend of a flattening yield curve continued – with the spread between the 2-year and 10-year notes narrowing a further 4 basis points from 20 (down from 28 in August) to 16 – amidst the Federal Reserve's recipe of higher short-term rates for the rest of 2005.

And in the currency markets, the dollar strengthened against the euro and the Japanese yen, on expectations of further tightening by the Federal Reserve.

Hedge Fund Performance

The macro strategy was the best-performing among hedge funds allocating to North America, posting excellent returns at 3%. Funds have benefited from the global trends of rising inflation and inflation risk on one hand and steady economic growth on the other.

Equity long/short funds were the next best return generators in the region, up 1.65%. Oil service stocks were the key drivers, especially those in a position to provide the requisite equipment and services for the rebuilding of the Gulf Coast infrastructure.

Convertible arbitrage funds turned in decent returns, considering all the negative press and poor performance earlier this year. However, due to the contraction in convertible assets of between 30-50% over the past year, convertible hedge funds are finding it more difficult to eliminate inefficiencies quickly.

Event-driven funds have had five consecutive months of good returns so far. September's returns were driven by the impressive momentum shown by the M&A markets. Deals of note in the US were Oracle's US$5.4 billion bid for Siebel, and the announced alliance between Wellchoice and Wellpoint – an example of continuing consolidation in the health insurance sector. Statoil's acquisition of Spinnaker, a Gulf of Mexico-focused exploration company, also lent a fillip to the oil sector.

CTA/Managed futures funds, on the other hand, had to contend with highly volatile energy markets and were consequently the worst performers for the month. For instance, the price of unleaded gasoline was down 5% after trading in a range of about 30%, while that of natural gas was up 20% and heating oil remained more or less flat. This volatility is reflective of market participants trying to assess the extent of the damage caused by the two hurricanes, in their investment decisions.

Going Forward

Going forward, the energy sector in particular is expected to remain unstable and illiquid, as the problems are structural and need to be solved over time. The resulting pressure on inflation and consumer confidence may create opportunities for hedge funds. Also, despite the damage inflicted by the hurricanes, the prospect of increased fiscal spending should keep the US economy going in the coming months. Other opportunities for funds may be sought in the inflationary pressures. On the negative side, corporate trends such as the recent corporate accounting issues at Fannie Mae and REFCO, and Delphi's bankruptcy filing, may add to pressure on high yield spreads.

Europe

Market Round-up

European equity markets rallied in September on the strength of corporate data (earnings as well as corporate activities), and showed continued resilience to rising commodity prices. The MSCI Europe Index rose 4.4% and the CAC40, the main industrial index on the Paris Stock Exchange, rose 4.6%, in September. Attractive valuations, increased M&A activity and share buybacks, have all had a positive impact on market movements. But there is a dichotomy in the earnings pictures painted by the industrial and the retail sectors. While the former are enjoying strong demand, the latter are suffering from weak demand from consumers and rising prices on the supply side.

On another level, Europe has a different sort of dichotomy – politically both the government and the people are resilient to reforms. But economically, corporate earnings and cash generation are good, and are driving activity in the capital markets.

In the bond markets, concerns over growth and inflation amidst a higher interest rate environment in the US, were not without their mirror effects in Europe. For instance, 10-year yields rose from 3.1% to 3.15% in Germany. On a related note, the impact of the German election outcome on the markets is yet to be fully evaluated.

In Eastern Europe, the revision of the budget deficit in Hungary sent the bond and currency markets southward. Turkey's impending official commencement of EU talks (3 October), has increased overall market volatility. Russia's bond markets remain strong, backed by a fiscally efficient government. Likewise with its equity markets, driven by high metal and oil prices. There is also high liquidity in the market, with strong foreign inflows.

Hedge Fund Performance Tables

Multi-strategy funds were the top income generators in Europe, rising by over 4% for the month.

Funds allocating to the commodity markets on the other hand, were the worst performers for the month, posting negative returns of 0.4%. This mirrors the trend seen in hedge funds allocating to North America, and is for the same reasons too.

Going Forward

Europe seems on course to sustaining its bull run with low valuations and operationally sound companies. Inflation and expectations of inflation do not seem to be a cause for immediate concern, despite the rising energy prices. This would be a conducive environment for skilled stock pickers.

Japan

Market Round-up

The Japanese markets had an incredible month in September. The TOPIX rose 11.5% while the Nikkei 225 rose 9.3%, for the month. The bullish trends seen in August followed through, fuelled by the (positive) outcome of the Japanese general elections as well as healthy economic data. And the minimal impact of global commodity prices on the markets reinforces the trend – also seen in August – of Japanese markets performing well independently of the US markets.

The anticipated expansionary cycle would be different from other recoveries as domestic demand is playing a key role. Movements in the equity and real estate markets further corroborate this. Foreign institutional investors remain very strong buyers in the market.

Hedge Fund Performance

Amidst prevailing market sentiment about the end of deflation and start of the expansionary cycle in the near term, the key performing sectors in the Japanese equity markets were banking and retail stocks.

Event driven funds also posted very high returns at 3.5%. September saw a rise in the number of stock splits. Also there were realised profits for funds, from M&A deals invested in and whose merger dates fell within the month, such as those of Bank of Tokyo-Mitsubishi, and CITIZEN.

Relative value funds are the seeming under-performers for the month, but even they have bounced back from the negative territory in August, to posted good returns at slightly over 0.8%.

Going Forward

The Bank of Japan is hinting at hiking interest rates. Coupled with an increasing corporate demand for funds, the interest rate hike will prove beneficial to the banking sector. Inflation is unlikely to pose a problem in the near future, as the markets expand. The rising markets (there have even been recent announcements of strong Japanese export data) should afford ample opportunities for hedge funds, especially in the equity and bond markets.

Asia ex-Japan

Market Round-up

Asian markets also had a very good run in September, with Korea and India as key drivers. The MSCI AC Far East ex-Japan Index rose 4.8%, while the KOSPI rose an incredible 11.9% and the BSE Sensex was not far behind at a 10.4% boost. In the Asian bond markets, the reversal in US yields has had the effect of limiting bond prices within a tight range. Corporate Korea's share buybacks also boosted the market to new highs.

In India, the driving factors for the strong run were steady bond yields, declining inflation and global liquidity.

China's markets also finished the month higher; the Hang Seng Index was up 3.5% for the month. As well, China is experiencing a build-up in liquidity – as evidenced by July's trade surplus numbers (US$10.4 billion) and a surge in equity from IPOs and share placements – suggesting a bullish forecast for October. China also decided to widen the daily trading range of the yuan against non-USD currencies. Another factor fuelling this bullish forecast is the much-anticipated China Construction Bank IPO. At an estimated US$6 billion, it is being billed as one of the largest IPOs in Hong Kong.

In Australia too, the equity markets performed well, with the S&P ASX rising 5.1% amidst positive economic (GDP rose 1.3% in Q2 2005) and corporate earnings data and strong commodity prices. These robust figures were also reflected in a cheapening of bond prices, with 10-year bond yields rising from 5.05% to 5.36% over the month.

Taiwan continues to be the worst performing economy in the region, with a problem-riddled banking sector and a capital intensive technology sector. Furthermore, Taiwan may also be suffering from a fall in Chinese imports of its finished goods, as China builds up its own domestic capabilities.

Hedge Fund Performance

At 2.8%, Asian hedge funds allocating to the equity long/short strategy posted the best returns for September. In addition to the rising equity markets, these funds were further assisted by their traditional long-bias as compared to hedge funds allocating to other regions. Impressive gains were made in the hospitality and industrials sectors in India and the banking sector in Korea.

Convertible arbitrage funds in Asia too were sensitive to the volatility in the global energy markets, (Japan being the exception for reasons elsewhere stated). Consequently, they had a bad rap in September, returning negative 0.5%.

Going Forward

Going forward, Taiwan has shown a slow recovery during the month and is expected to continue on that path in the coming month. Activity in the Asian credit markets is also set for a rise in the coming months, with new issuance in high yield instruments in the pipeline. Overall, the key Asian regions of Korea, China and India continue to hold opportunities for hedge funds for the rest of the year, although the immediate months may see some profit-taking following the all-time highs in some of the equity markets, such as those in India and Korea.

Latin America

Market Round-up

Latin American markets had a terrific month in September, benefiting from a combination of strong fundamental – growth, healthy trade and fiscal conditions – and technical factors. The MSCI EMF Latin America Index rose a spectacular 15.5%, driven primarily by oil and energy-related stock rallies.

The Brazilian markets rose sharply in September on the combined strength of a cut in interest rates and strong commodity prices. The corruption scandal and the ensuing political crisis show signs of fizzling out, a trend already seen in August in the indifference of institutional investors. Brazil has even managed to make an international bond issue – it's first – denominated in real and equivalent to US$1.5 billion.

In Argentina, economic data has been very positive with GDP growth of 9% year-on-year exceeding market estimates. However, inflationary pressures are on the rise and several sectors of the economy are reaching full capacity.

Mexico bounced back from its weak performance in August, also driven by rate cuts and positive economic data.

Hedge Fund Performance

While long/short funds – both onshore and offshore – took handsome gains of over 6% each amidst soaring equity markets, one glaring contrast between on and offshore funds is in the performance of macro funds. For the latter, it was among the best-performing strategies for the month (+4.5%), whereas for the former, they were the worst-performing strategy, posting negative returns of close to 0.8%.

One possible explanation is that the Latin American markets offer good onshore/offshore arbitrage opportunities for hedge funds, and they have recently witness strong surges in liquidity. To take the example of the Brazilian real, there has been a surge in capital flow into offshore hedge funds in September, owing to investors interested in taking long positions in the real and short positions in offshore currencies. As a consequence, the Brazilian real has strengthened over the month. This could have caught the onshore funds on the wrong side of the bargain.

Strategy	Sep 05	Aug 05	YTD 2005	2004	2003
CTA/Managed Futures	-0.16%	-2.22%	-9.61%	23.74%	19.91%
Event Driven	3.44%	3.70%	24.36%	39.54%	36.13%
Fixed Income	1.65%	1.75%	14.11%	15.60%	39.25%
Long/Short	6.57%	3.51%	18.03%	35.27%	55.83%
Macro	-0.83%	0.76%	4.07%	6.63%	9.80%
Multi Strategy	3.24%	1.47%	14.32%	19.78%	36.48%
Relative Value	8.40%	0.96%	2.20%	48.56%	54.11%
All Strategies	3.64%	1.70%	13.41%	22.29%	36.96%

Going Forward

Short-term market sentiment on emerging markets will continue to be bullish, and September's performance numbers can only reinforce this sentiment. The markets will see continued liquidity, with more foreign investors wanting a share of the emerging market return pie.

Conclusion

Despite the seemingly unfettered performance of emerging markets and Japan (weathering as they did, the twin hurricanes and rising oil prices), these very same factors could make the anticipated interest rate hikes in the US that much more pronouncedly felt for the US consumer. Inflationary pressures are looming on several of the regional investment horizons, and hold potential negative repercussions for global equities as well as global growth trends. Nevertheless, in the months to come, hedge funds can expect several pockets of opportunities, as some of the regional bull runs are sustainable by market fundamentals. Also merger activity is on the rise, with more than 25 multi-billion dollar deals announced during September alone.

Footnotes

¹Based on 95% of the NAV data for September received to date (27 October 2005).

²The All Strategies Index is a separate index and derives its value not only from the actual performance of the listed strategies for the investment region but also from the strategies which are not listed (due to strict Eurekahedge indices guidelines) but having the same investment mandate.