Hedge funds got off to a strong start in 2007 on the back of a healthy run-up to the end of 2006, with January returns of the composite Eurekahedge Hedge Fund Index at 1.2%1. Performance was broad-based as well, with most regional and strategic mandates returning close to or upwards of 1%, as profits came from across several asset class markets.
Equity markets continued their rally during the month, drawing support from the stronger US employment, housing and consumer confidence data, robust 2006 Q4 earnings, and a benign inflationary outlook; the MSCI World Index rose 1.2% for the month. With economic fundamentals remaining strong and interest rate cuts unlikely in the near term, that helped push rates further up in January which resulted in profitable bond and interest rate markets. The high yield market too continued to rally, driving credit spreads to historically tight levels. Furthermore, healthy jobs data in the US and Europe, coupled with the unexpected rate hike by the Bank of England (to 5.25%) lent support to this trend towards higher rates.
In contrast, price movements in the commodity and currency markets were more mixed. Energy market trading started the month well enough, as oil prices fell sharply from US$62 to US$51 per barrel on growing US inventories and milder weather. This, however, reversed as prices bounced back to US$58 into month-end on the back of the announcement of US plans to increase their strategic oil reserves, geo-political tensions in Iraq, and Saudi Arabia’s confirmation about implementing the OPEC production cuts in February. Colder weather towards the month-end also boosted demand and natural gas prices rose upwards of 20%.
In the foreign exchange markets, the Japanese yen continues to be the main funding currency for carry trade. Coupled with the Bank of Japan’s decision to leave rates unchanged at 0.25%, this weakened the yen against the US dollar (the yen fell from 119 to 122 against the dollar). On the other hand, the Bank of England surprised the markets by raising rates to 5.25%, boosting the British pound to multi-year highs against the dollar. Short dollar positions, however, proved less profitable over the month as the dollar strengthened over the month in a positive economic environment that made rate cuts by the Federal Reserve unlikely.
In light of the aforementioned markets movements, arbitrageurs (+2.2%) and trend-following hedge fund strategies with a specific market focus, such as long/short equities and fixed income (up 1.3% and 1.2% respectively), had a very good month in January. But opportunistic managers (+2.6%) were the month’s top revenue generators as new issuance and M&A activity continued on at a fair clip during the month.
In terms of regions, while performance has been good across the board, European managers posted the biggest gains for the month (+1.9%) as the underlying markets had a strong start to the year in the form of healthy deal flow, positive earnings and economic data, and falling oil prices. Asia ex-Japan managers too had a terrific month (+1.8%), on the back of fundamentally strong markets, especially in China and India.
A more detailed breakdown of regional hedge fund performance follows in the sections below.
Directional macro and long/short equities managers returned a healthy 1% each for January, as North American equity markets weathered difficult markets during the initial few days but closed the month in positive territory, with large-cap stocks marginally outperforming their smaller sized peers. The S&P500 Index was up 1.4% for the month.
Arbitrage and relative value players also had a good run, returning about 1.5% each for the month, as the mixed markets in base metals (driven largely by the supply-demand dynamics of the individual metals), energies and currencies offered a number of profitable opportunities.
But the month’s best returns in the region came from event-driven and distressed debt managers (2.7% and 2.8% respectively). The high yield market continued to rally, tightening credit spreads and benefiting credit-sensitive securities. Furthermore, the start of the earnings season mid-month coupled with brisk M&A and new issuance activity levels provided profitable opportunities. For instance, 36 merger deals closed successfully or were taken off during the month, while eight new issues came to market in the convertibles space raising US$1.8 billion.
Most European hedge fund strategies had a terrific start to the year, with event driven (+4.6%) leading the pack, followed by fixed income (+3%) and long/short equities (+2%). Long/short managers benefited from the fact that European equities started the year on a very positive note on strong corporate (M&A as well as earnings) and economic data, and falling oil prices. German equities were among the best-performing in the region, closing positively for the eighth consecutive month. The MSCI Europe Index rose 1.6% for the month.
Fixed income managers, on the other hand, were assisted by the healthy demand in European bonds and high yield securities. While new issuance in the convertibles space remained subdued (four new deals together worth slightly over US$1.3 billion), funds were still able to take profits in them as they all traded up.
As for event-driven strategies, profitable opportunities were to be found in the stock-specific volatility surrounding the earnings announcements, and in special situations in M&A (E.ON, Accor), activity turnaround (Siemens, Saint Gobain) and minority buybacks (Allianz, Ciments Francais).
Eurekahedge European Hedge Fund Index
Japanese equities continued their rally from November lows, with the Topix rising 2.4% on the back of a weaker yen and expectations of earnings surprises. The decision of the Bank of Japan to keep interest rates unchanged (at 0.25% per annum) lent support to the bullish mood among investors and led to a further weakening of the yen. The Bank of Japan left rates unchanged given the absence of any sign of inflation and a decline in domestic demand (by 1.9%) in December.
Amid this backdrop, most hedge fund strategies in the region had a decent month, returning close to or slightly upwards of 1%, with the exception of multi-strategy funds (-0.7%). Event driven was the best-performing strategy for the month, returning 1.3%. In addition to the general rise in M&A activity and private equity interest in the Japanese markets, some of the event-driven managers took advantage of the anomaly in price movements in connection with the public offering of stocks and the rebalancing of Topix.
Long/short equities (+1%) was another of the better-performing strategies during the month. Longs performed better than shorts, particularly during the last week of the month when there was significant buying of higher yielding sectors such as utilities and steel. On a more general note, shorting opportunities are being affected by recent M&A speculation on traditionally defensive companies.
Eurekahedge Japan Hedge Fund Index2
The New Year saw Asia ex-Japan markets rallying sharply with China and India basking in the limelight of regional investor interest. Chinese funds were top performers with the exception of funds investing in property stocks which were affected by the government policy to enforce Land Appreciation Tax. As a result, funds were moved from China related shares to Hong Kong related shares, which in turn drove the Hang Seng up 5.9%. MSCI China was up 14% while Taiwan and Korea were flat during the month of January.
In India, high volumes of initial public offering activity (notably by Gujarat State Petronet and Tech Mahindra which more than doubled respective share prices) and high real estate valuations pushed long/short equities funds to highs of 2.2% on the Eurekahedge India Long/Short Equities Index.
Australian stock prices continues to march upwards with the S&P/ASX 200 Index, gaining 1.8% for the month against rising crude oil prices and a 1.4% price increase in gold for immediate delivery. Australian multi-strategy (+2%) and long/short equity (+1.9%) funds benefited greatly on the back of the healthy equity market.
On the flip side, the Korean market has begun to show signs of a slowing economy (KOSPI dropped 5.2%) with the telecom sector falling sharply. While heavy industries, such as energy, shipbuilding and engineering, benefitted greatly from lack of supply and strong demand within their industries, government curbing of property prices led share prices to drop 9.3% in January. The declining macro momentum may dampen investor outlook over the coming months but funds delving on the long side in heavy industries have much to gain.
Markets in Thailand (-2.0%) too closed in negative territory, with the Thai baht (+1.9%) at its strongest since 1997 in the offshore market due to low currency availability. While funds in the Eurekahedge Index closed at an average of -4.8%, general market uncertainty (especially after the interest rate cut) could prove favourable for both long and short gains in the following months.
Emerging markets in Latin America started the year on a worrisome note – from a free-markets advocate’s point of view – as the region continues to lean further towards socialism. For instance, Venezuelan premier Hugo Chavez announced the nationalisation of CANTV, the national phone company, but not at the prevailing market price. Shareholders were also told that rejecting the offer meant that CANTV would be declared a public utility and its assets expropriated.
This trend, however, is not a new or unexpected one and provided interesting shorting opportunities to equity long/short managers during the month.
Broadly, the mood in the region’s equity markets was one of profit-taking (after the impressive runs in late 2006) and a stepping-up in volatility. The MSCI Latam Index has in fact declined 6% during the first half of the month before recovering lost ground and closing the month up 1.5%. The key driver for this volatility was continued uncertainty regarding US interest rates and concern regarding US economy in general.
That said, the markets in Brazil, Argentina and Mexico continue to support a more optimistic long-term view of economic prospects in the region. For instance, in Brazil, President Lula announced a “Program for Accelerated Growth” promising structural reforms aimed at boosting private enterprise and GDP growth.
Amid these market movements, the region’s equity long/short managers posted robust gains at +2.5%. Fixed income managers too had a positive month (+1%) as local market debt plays, particularly in Argentina, continue to attract capital as economic indicators point towards sustained growth.
Eurekahedge Latin American Hedge Fund Index
The near-term outlook for hedge fund performance remains much the same since our last review as markets are fundamentally strong, the new issuance and deal flow calendars look busy and there is healthy speculation about the data emanating from the ensuing earnings season. This affords ample opportunities for equity long/short and event-driven managers, and directional players in general. Equity market volatility is at multi-year lows and this is expected to pick up as well, benefiting high yield managers and arbitrageurs in general.
Opportunities may also be found in the currency markets, as the yen continues on its weakening slope. The communiqué issued at the end of the G-7 meeting in early February made no express reference to the same, but the Bank of Japan monetary policy meeting next week may have the potential to put an end to the relentless yen devaluation. We could also see some stronger economic data out of Japan pointing in the same direction.
1 Based on 46.35% of the NAV for Jan-2007 as at 12-Feb-2007.
2 The Eurekahedge Japan Hedge Fund Index is a Octarate 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.