Performance Overview

Hedge fund returns rebounded in March after a flat month in February – the benchmark Eurekahedge Hedge Fund Index¹ rose a handsome 2% – and resumed the uptrend seen in the preceding months on the back of rising markets, closing the first quarter of 2006 on a very positive note (+5.5%). The month's performance came amidst favourable markets characterised by high levels of corporate activity, rising equity markets and tightening credit spreads.

In the global equity markets, the broad theme for the month as well as for the quarter as a whole was a liquidity- and momentum-fuelled uptrend, healthy corporate earnings data and strong M&A activity. This was clearly reflected in the performance of long/short funds (see graph below) during the same period(s).

Event-driven managers continued to thrive on the high levels of corporate activity and the increasing incidence of competitive, if not hostile, bidding situations. Consequently, event-driven funds did well over the first quarter of 2006. More specifically, March marked another strong month for M&A deals with the cumulative value of announced deals at close to US$400 billion, diluting the impact of the major expected deals that have failed to fall through (the NASDAQ announcement not to buy LSE, for instance).

Energy markets finished the month up 8.8%, as measured by the Goldman Sachs Energy Index, but had to contend with a significant correction mid-February. This has pulled down first quarter 2006 performance of CTA funds to 3%, but they are expected to perform well in the near-term given rising energies and metals, and the healthy gains in March. The key factors driving prices up are the strong demand from Asia (in the case of metals) and the building up of inventories in anticipation of the driving season (in the case of energies).

On the other hand, fixed income managers (up 0.5% on average) found themselves on the short end of the month's returns spectrum, as interest rates increased globally and credit spreads tightened. Although the quarter-point rate hike announced by the Federal Reserve on 28 March was largely expected, bond markets were unnerved by the stronger-than-expected economic data and fears of a tightening labour market.

The Fed's rate hike and the accompanying re-affirmation of its hawkish stand on inflation, together with the Bank of Japan's announcement of an end to its zero interest rate policy and the ECB's hike (by a quarter-point to 2.5%), both in early March and also largely expected, were notable events during the month. The Fed's announcement marks its 15th consecutive rate hike and might continue in the face of rising inflation. And yet, this has failed to dampen investor enthusiasm across global equity markets.

Looking at performance by fund geographic mandates, hedge funds allocating to emerging Asia turned up tops for the month as well as the quarter, posting solid gains at 3.8% and 10% respectively, on the strength of rising regional equities. The Japanese markets saw a recovery of confidence, while strong liquidity inflows and corporate data drove up Chinese stocks. US funds, especially those with exposure to energies and small- and mid-cap companies, also fared rather well, returning 2.1% for the month. As key regional equity markets registered healthy gains, Latin American funds (down 0.6% for the month), on the other hand, saw some erosion of value owing to a channelling away of some of the global liquidity parked in these markets, rising political uncertainty and increased capital spending. The graph below offers a clearer look at comparative regional hedge fund performance, while the following section elaborates on the performance trends in each of these investment regions.

March 2006 Performance by Investment Region

North America
Europe
Japan
Asia ex-Japan
Latin America

North America

Market Overview

In North America, the equity markets had a strong month in March as the NASDAQ Composite rose 2.6% and the MSCI North America Index, 1.2%. In general, small-cap stocks proved far more profitable during the first quarter. To illustrate, the small-cap focused Russell 2000 Index rose 13.9% for the quarter, while the S&P 500 rose 4.2% over the same period. In the new issues space as well, the markets continue to see steady activity with several mid-sized offerings during the month, as well as opportunities in the secondary market.

The strong corporate and economic data hurt the bond markets, with US treasuries reaching new highs – yields on 10-year notes rose 30 basis points to 4.86%, while those on 2-year bonds climbed to 4.83%.

The US commodity markets rebounded in March (the CRB Index rose 2.5%), gaining back most of the ground lost in February, with energies and metals leading the others. The month saw most commodities setting multi-year highs. The key factors driving prices up are the strong demand from Asia (in the case of metals) and the building up of inventories in anticipation of the driving season (in the case of energies). Amidst this bullish environment, the Eurekahedge North American CTA/Managed Futures Hedge Fund Index rose 2.3%.

Hedge Fund Performance

Distressed debt funds turned in the best returns for the month (+2.6%) as credit spreads tightened in the asset-backed securities (ABS) space due to strong demand, and ABS new issues volume reached record highs (about US$270 billion for 2006 Q1). Traders in distressed securities continue to be focused on oil price volatility and auto sector headlines.

Rising commodity prices, coupled with continued high levels of corporate activity and strong equity markets, ensured that most conventional hedge fund strategies had a terrific month in March (the Eurekahedge North American Hedge Fund Index was up 2.1% for the month, while the CTA, equity and event-driven components all closed the month around the 2.5% mark). This has translated into robust gains for multi-strategy hedge funds as well, with the Eurekahedge North American Multi-strategy Hedge Fund Index up 2.3%. This was in spite of the overall tightening credit spread environment.

Even the weaker strategies for the month such as fixed income and macro funds posted returns close to 1%, as opportunities were to be found in the weakening directional movement of bonds and the US dollar.

Europe

Market Overview

Economic data in Europe was generally positive during March. In the equity markets, energy and commodity stocks posted the best returns. Also, equity valuations continue to be attractive given the strong fundamentals, despite markets expecting the ECB to embark on a more aggressive tightening cycle. M&A activity too continued to be very strong in the region.

While the improving business environment in Germany and Italy (the German IFO Index rose to new multi-year highs) and generally strong economic and corporate data helped the euro strengthen against other major currencies, it spelled a continuing bear market in the European fixed income space. European bond yields moved up 30-35 basis points; the ECB hiked as expected on 2 March.

One notable departure from past performance patterns, however, was that emerging European equities could not shore up the continental average. Soaring energy and metal prices failed to benefit eastern European markets in general, which remained flat during the month, and Russian and South African equities in particular, which declined during the same period. This was owing to the fact that the fundamental strength of the markets was outweighed by the parallel upward shift in the US, European and Japanese yield curves.

Hedge Fund Performance

The performance of European hedge funds during the month was largely a reflection of movements in the respective capital markets – long/short and relative value funds turned in the best returns for the month (2.2% and 2.1% respectively); event-driven funds rose 1.9% in a particularly strong month for M&A deals as corporations vied with private equity firms in identifying potential candidates for acquisition; and CTA/managed futures climbed 1.9% helped along by soaring commodity prices and a strengthening euro.

Fixed income funds were the worst performers for the month in Europe, shedding 1.2% in March, given the sustained bearish trend in the bond markets since September 2005.

Japan

Market Overview

The Japanese economy continued to gain momentum. The equity markets rallied strongly as investors returned to the markets following the easing of last month's year-end selling. The Nikkei reached a five-year high at 3.8%, following a difficult start to the month. Corporate earnings estimates are on the uptrend against the backdrop of rising consumer confidence and signs of a broad-based recovery. Equity valuations again look attractive as profits from the overbought positions were secured in the past few months.

Hedge Fund Performance

The volatility of the initial two months of 2006 (associated with the year-end selling and the Livedoor scandal) has pushed the Eurekahedge Japan Hedge Fund Index into negative territory, but Japanese hedge funds have recovered most of the lost ground with the uptrend witnessed in March, as can be seen from the graph below.

On the flip side, this volatility has widened the scope of opportunities for long/short funds as the equity prices are still in the process of factoring in recent market developments. Consequently, the long/short equities strategy was among the better performing strategies for the month at 1.8%. But the clear winners were event-driven funds, whose returns of 4.3% for March have helped them close the quarter in healthy positive territory (+4.7%).

Asia ex-Japan

Market Overview

In the rest of Asia too, most equity markets completed the first quarter on a steady and positive note. The MSCI Asia ex-Japan Index rose 1.8% for March and 7.4% for the quarter. The markets continued to attract huge inflows of liquidity, even channelling some away from other emerging markets, as confidence in the Asian markets is on the rise. Commodity and energy prices too, spiked higher during the month.

Asian high yield markets too were stable in March, outperforming US treasuries by a good margin, in a case of liquidity-fuelled demand outstripping constrained supply. High yield sovereign issues accounted for a good quarter of the US$9.6 billion in the Asian new issues space in March.

India was the best performer for the month among the regional markets, with the S&P CNX Nifty Equity Index rising an outstanding 10.7%, fuelled by the large liquidity inflows (US$3.9 billion for the quarter) and the lack of any significant policy changes in the Union Budget. M&A activity was also at healthy levels. Some key deals were the announced spin-off by the Reliance group of its petroleum arm, through an IPO in April, and the media conglomerate Zee Telefilms' spin-off of its content and cable units.

Global investors remained firmly bullish on China, given not only good earnings results and strong IPO activity, but also plans by the Chinese government to allow margin-trading and short-sales. The H-Share Index was up 3% for the month and a whopping 25.8% for the quarter. Talks of RMB valuation continued in March, and the currency closed at a new multi-year high of 8.02 per USD, partly fuelling the gains in the H-Share Index as Chinese stocks are believed to benefit from the appreciation.

Australian equities resumed their upward trend after the pause in February, with the S&P ASX 200 rising 4.7%, boosted in turn by strong commodity prices. This was accompanied by positive data on the corporate (strong earnings and deal flow) as well as economic (spike in household incomes and rebounding employment rates) fronts.

Korean and Taiwanese markets were hurt by mixed to negative reports from key players in the mobile and PC manufacturing spaces. The TAIEX closed the month up 0.8%, but only after significant intra-month volatility.

Hedge Fund Performance

Amidst such broad-based uptrends in terms of regions as well as asset classes, multi-strategy funds were the best performers for the month, returning a whopping 5.2% for March alone, and 10.8% for the quarter. Long/short hedge funds too did extremely well (+3.9%) amidst a liquidity-fuelled uptrend in key regional equities.

Declining volatility in the convertibles space was offset by the tightening credit spread environment and convertible arbitrage hedge funds had another terrific month in March, rising 2.8%.

Latin America

Market Overview

The MSCI EMF Latin America Index fell 2.6% in March, as allegations of corruption against the incumbent finance minister led to news of his resignation. The Brazilian currency weakened by nearly 5% amidst fears over continuity in the fiscal and inflation policies. In Mexico, the peso was devalued by 4%, in part owing to pressure from the falling yield spread between Mexican and US government bonds. Argentinian bonds too fell in line with global bond markets, despite a marginal upgrade to the country's sovereign rating.

In the Latin American treasury markets, the tightening cycles signalled by the ECB and the Bank of Japan in early March pulled bond prices down. Prices failed to recover in the second half of the month, in the absence of any indication in the Fed's announcement of an end to the tightening cycle.

The strength in commodity prices, led by oil and metals, failed to counterbalance the afore-mentioned market movements.

Hedge Fund Performance

In light of the month's market activity described above, Latin American hedge funds had a relatively subdued month in March as compared to the rises seen in the recent past. Offshore Latin American funds got the worse end of the downtrend in the markets, with the offshore index shedding 0.8% for the month, while the onshore index rose just 0.5%.

Among the onshore funds, arbitrage (+1.8%), macro (+1.4%) and fixed income (+1.3%) players were the better performers for the month, clearly benefiting from opportunities afforded by the movements in the bond and currency markets. The broad-based market decline also explains the performance of multi-strategy funds, which mostly had a flat month, with the onshore component rising 0.5% and the offshore component falling 0.1%.

In Closing

To conclude, given that the markets are fresh off the short-term correction in February, the next pause may reasonably be expected to be some time away and then only limited in its effect given the fundamental strength of most of the markets in review. We believe the M&A, equities and commodities themes will continue to dominate in the next few months. Commodity prices have, as a matter of fact, been scaling new multi-year highs in April.

In Japan, the announced end to quantitative easing is largely a positive for the markets, as it signals the end to Japan's 15 years of deflation, and a return to normal economic growth conditions. Although setbacks in the initial months of the year translated into poor performance during the first quarter (-0.4%), the positive investment environment promises good opportunities in the near term.

Moving on to the risks, inflation and interest rate worries are resurfacing, partly owing to the rising oil price, as are those over the political situation in the Middle East. Concerns have also begun to grow over the simultaneous short-term rate hikes by key central banks. The markets are now awaiting the next Fed meeting on 10 May, as the March meeting failed to give any indication about a possible timeline for an end to the monetary tightening cycle.

Going by the fundamental economic forces at play, however, the longer term positive outlook of the markets does not warrant change.

Please visit http://www.eurekahedge.com/indices for daily-updated numbers on index returns for March.

Footnotes

¹ Based on 86.58% of the NAV for Mar-2006 as at 28-Apr-2006.

² The 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.