2006 Hedge Fund Performance Commentary – The Year in Review
Hedge funds had yet another strong month in December (+1.8%1) and closed the year 2006 up a healthy 13.4%. Returns during the month were broad-based as well, with most regional and strategic mandates returning 2% or more. This review attempts to examine and enumerate some of the key factors responsible for these strong returns, while also looking ahead at 2007’s investment horizon as it applies to hedge fund returns. This review is organised into two broad sections focusing on the style-driven and region-driven aspects of hedge fund performance during December 2006 as well as the year as a whole, and a third section focusing on the outlook for 2007.
Performance by Strategic Mandate
Hedge fund performance during December was driven chiefly by long exposure to equities (as strong economic growth and continued high levels of M&A activity drove equity prices higher during December), short exposure to energies (as mild weather in the US and Europe resulted in lower demand) and profitable plays in the foreign exchange markets. As a result, long/short equity (+2.5%), relative value (+2.2%), macro (+2.1%), and consequently, multi-strategy (+2.5%) hedge fund managers had a terrific month in December. Sustained merger activity levels also helped event-driven funds generate robust returns (+2.2%). A comparison of the month’s performance across strategies against that during the previous month as well as during the year is charted in the figure below. CTA/Managed futures funds seem to be the only strategy bucking the general trend of matching November’s performance, affected as they were by the lower-than-expected seasonal demand for oil and gas.
To review the performance of various hedge fund strategies in 2006, we compare two measures of the same in the figure below – absolute return and risk-adjusted return (ie Sharpe ratio2). On the basis of the combined measure, style-based performance during the year may be classified into four broad categories in the order of preference of a typical risk-averse investor: high-return/low-risk, low-return/low-risk, high-return/high-risk and low-return/high-risk. Assuming a Sharpe ratio of 1 or above as indicative of a ‘low-risk’ strategy and annual returns of 12% or above as indicative of ‘high return’, the figure below puts almost five of the ten strategies studied squarely in the top-performing category of high-return/low-risk: Event Driven, Distressed Debt, Arbitrage, Relative Value and Multi-Strategy.
In a year that saw significant activity levels (new issuance as well as secondary markets) in the M&A and high-yield spaces, the superior performance of opportunistic strategies such as event driven and distressed debt can be easily explained. Arbitrage and relative value players, on the other hand, benefited from the spikes in volatility owing to the strong market correction seen mid-year (between May and July), as also the general uncertainty surrounding inflation and the Federal Reserve’s rate hike decisions round the year. Long/short equity funds had a decent run as well, generating superior annual returns (+15%) albeit at a slightly higher risk (Sharpe ratio of 0.8).
On the other hand, fixed income, a traditionally low-return/low-risk strategy, has indeed had the most stable and consistent returns, with only two nearly flat months through the year and better performance (+8%) than the previous year (+6.4%).
And lastly, on the downside, the intra-year volatility, particularly in the energy markets, had a negative impact on CTA/managed futures funds, and, to a lesser extent, directional macro funds.
Performance by Geographic Mandate
We carried out an analysis similar as above, of performance by regions of hedge fund investment. While performance patterns have, in the main, panned out predictably – emerging market funds outperformed their developed market peers by quite a margin, as can be seen from the following figure – returns have generally improved almost across the board over the previous year’s. The Eurekahedge Asia ex-Japan Hedge Fund Index had one of its best years since inception (in 2000) – and certainly its best year in the last three – with 2006 annual returns at a whopping 30.3%. Returns in Latin American funds were impressive too, at 24% during the same period. This was in part driven by a substantial influx of liquidity into these markets.
Hedge funds allocating to North America also nearly doubled their returns (in percentage terms) between 2005 and 2006, at 11.3% on average. The lone region bucking the general upward trend was Japan. The Eurekahedge Japan Hedge Fund Index had its first year of negative returns in the last seven (-3.3%), as the long/short equity-heavy index was drawn down by the poor performance of Japanese equities, especially small caps. For instance, the JASDAQ index fell 33% in 2006, while the TOPIX was nearly flat at 2% over the same period. The TOPIX Small Cap Index lost 13% for the year. That said, Japanese stocks launched into a tail-end rally by rising nearly 5% during the last month of the year. While Japan-focused long/short managers could not match this performance given their de-risked portfolios in recent months, they still returned an impressive 1.6% for December.
Emerging Asia was clearly the best-performing region in 2006 given the twin high-growth markets of India and China. Even during the severe market corrections mid-year, when losses in emerging markets funds were accentuated by the huge outflows of liquidity (as risk appetites shrank globally), China was going through an export-driven positive cycle and surging capital inflows. A case in point was Bank of China Ltd’s IPO, which was oversubscribed by about 32 times and whose bids reached close to US$85 billion. This has helped diversify risk away among broader Asia ex-Japan focused funds. This is clearly reflected in the comparison of risk-adjusted returns across regional hedge fund allocations. Asia ex-Japan funds generated not only the best absolute returns among all regions for 2006, but also the best returns per unit of risk.
US equity markets continued their rally into December on the back of tame inflation data, falling oil prices, better-than-expected home sales figures and expectations of Federal Reserve rate cuts in early 2007. The S&P500 closed the month up 1.3%, while the Dow rose 2% over the same period. But conditions were not entirely smooth as the tech-heavy NASDAQ fell. This partly explains the 0.5% return that North American long/short managers posted on average for December.
In the bond and interest rate markets, credit spreads in general tightened over the month with rising consumer confidence. Two-year US treasury yields rose 20 basis points to 4.81%, while 10-year yields rose by 24 basis points to 4.7%. As a result, fixed income funds posted modest gains at 0.6% for December.
However the best returns in North American funds during the year were made in opportunistic plays such as distressed debt and event driven, which returned 17.1% and 16.8% respectively in 2006. The high-yield market continued to rally into the year-end, rising 1.1% in December and 11.8% for the year. The new issuance markets on both the high-yield and equity fronts which remained active throughout most of the year, also played catalyst to the superior returns.
European managers were richly rewarded for good stock-picking skills and a long-bias amidst equity markets that staged a strong rally (the FTSE Europe Index rose 3.7%) amidst falling energy prices and speculation over the Fed’s rate cuts. The equity long/short strategy was the best performer in the region for December (+3%) as well as for the whole year (+12.8%).
Event-driven funds were the next best performer, also for December (+2.1%) and the year (12.2%), as M&A activity continued at a brisk pace. The merger of Norwegian oil giants Statoil and Norsk Hydro was one of the more noticeable blips on Europe’s M&A radar.
There was high trading activity in the fixed income markets as interest rates rose sharply on the back of stronger economic data and market expectations of a hike in short-term interest rates in the near term. This has helped fixed income managers chalk up impressive returns during December (+2%). The overall performance of the Eurekahedge Europe Fixed Income Hedge Fund Index for 2006 also doubled (in percentage terms) from previous year’s figures, at 10%.
Commodities, on the other hand, closed the year slightly down (-0.9%), with losses evenly distributed across sectors, culminating in another year of nearly flat annual returns (-1.3%).
Japan led the Asian equity market rally during December, with the Nikkei finishing December and 2006 on a strongly positive note (+5.9%). The rally was triggered by the Bank of Japan’s decision to leave rates unchanged for the year (albeit with a qualifier that it might hike rates soon, maybe even as early as January 2007), with large-cap stocks seeing the biggest gains. This is reflected in the December performance of Japanese long/short funds (+1.6% on average), shoring the annual return up a little to -3.4%.
The weakening Japanese yen also played its part in the large-cap equities rally. The yen was the main loser among the major currencies, weakening 3% against the US dollar and 2.5% against the euro. These market movements also afforded opportunities to relative value players who notched up an impressive 4.8% return for December, and 7% for 2006.
Event-driven funds profited from such names as NEOMAX, ISS and BELTECNO as the M&A market in Japan continues to be active.
Strong liquidity conditions and bullish investor sentiment about the ‘soft landing’ of the US economy pushed equity prices up in emerging Asia; the MSCI Asia ex Japan Index rose 4.3% for the month, the Hang Seng was up 5.3% while the Chinese H-share market was up a whopping 20%.
In India, on the other hand, equities finished the year with a bit of turbulence (the S&P CNX Nifty index closed December up a mere 0.3%) owing to an unexpected rate hike by the Reserve Bank of India, coupled with a weaker-than-expected production report. This together with Thailand Central Bank’s announcement of a tax on new portfolio inflows (this was subsequently reversed for equities, but still damaged credibility) notwithstanding, long/short equity funds allocating to Asia ex-Japan had an impressive run in December (+4.4%), bringing the annual returns to over 30%.
Fixed income players also had a terrific closing month (+4.4%) as the Asian credit market was very active during December. With firm employment data and stronger-than-expected home sales figures, US treasury yields rose. High-yield credits tightened marginally, but despite rate pressures, risky assets performed relatively well.
Latin American equities continued their upward trend in December, closing the year 2006 on a high note. The MSCI Latin American Equity Index was up 6.8% for the month and nearly 40% for the year. These superior returns were materials- and energy-driven, leading Brazil, Argentina and other local markets to record levels; the Brazilian equity market index IBOVESPA rose 33% for the year.
The Brazilian markets also witnessed a sharp year-end rally in local yields during December, helping funds secure healthy profits in relative value positions. Foreign debt too had a good month despite rising US treasury yields.
Most strategies in the region posted returns upwards of 2% for the month and upwards of 20% for the year, with long/short equity funds delivering the best returns for 2006 (5% in December and 28% for 2006).
Eurekahedge Latin American Hedge Fund Index
Outlook for 2007
Our outlook for hedge fund performance in 2007 remains positive, although markets might be choppy in the near term after the euphoric rallies of the last couple of months. The dominant theme in the underlying financial markets now is one of a global boom in M&A (the year 2006 marked a total of US$3.6 trillion in acquisitions), and large and/or cash-rich private equity funds making inroads into heretofore unexplored markets, emerging or otherwise (Japan, for instance). To illustrate the ‘cash-rich’ nature of these fund allocations, there are over 150 private equity funds that have assets in excess of US$1 billion. Barring any “shocks” (external or otherwise) at play (such as the failure of a large private equity deal), deal flow should continue on at a healthy pace. This should provide ample opportunities for hedge funds allocating to opportunistic plays.
New issuance is also on the rise, and not merely in public equities. For instance, total new issuance in the convertibles space in the US for December alone was US$13 billion, pushing the total for 2006 to US$71 billion. There is also more of a demand for local market debt as new issuers are increasingly accessing primary markets. Increased activity in the primary markets translates into the same in secondary markets, and this should lead to a pick-up in equity market volatility (from 2006’s low levels), among other things. This offers an interesting environment for value players, (convertible) arbitrageurs and skilled long/short managers.
There is also an emerging trend of local market debt in emerging markets. In the case of local corporate debt in emerging markets, most new issuers tend to be first-time borrowers. This leaves ample room for mis-pricing the debt owing to several factors such as lack of investor familiarity and/or lack of proper pricing mechanisms. Such mis-pricings also afford profitable long/short opportunities and facilitate the deepening of these markets.
This trend of broadening and deepening emerging markets, together with the combination of undervalued currencies, reasonable valuations and positive earnings growth, also support the positive outlook. China and India are cases in point, offering attractive investment avenues through an array of companies benefiting from the countries’ economic growth. Likewise, the fundamentals in Latin America are strongly positive – sustained growth in and expansion of economic activity, and strong balance of payments fundamentals prevailed in 2006.
Japan continues to be a mixed bag, with consumer confidence still eluding the markets despite healthy corporate earnings and better housing and industrial production. The positive factors might well trigger a persistent bullish stock market response in the year ahead.
Moving on to the risks, while investors seem to have adjusted to a “goldilocks” economic outlook (where inflation and economic growth are well balanced), expecting the Fed to cut rates in early 2007, there is still some uncertainty surrounding the Fed decision. Also, the possibility of a recession in the US and its impact on global growth are other causes for concern.
1Based on 53.85% of the NAV for Dec 2006 as at 15 Jan 2006.
2The risk-free rate used in the calculation is 4%, and the risk measure used is the (annualised) standard deviation of all the monthly returns of all the funds constituting a particular strategy.
3The Eurekahedge Japan Hedge Fund Index is a Novarate 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 have the same investment mandate.