The Eurekahedge Hedge Fund Index ended February up 0.6%1, doing reasonably well despite choppy markets towards the month’s close, as worldwide equity markets witnessed sharp drops of between 4% and 9%. Some of the key drivers of this decline were negative comments emanating from (former Federal Reserve Chairman) Alan Greenspan, continuing geo-political tensions in the Middle East, the Chinese government’s attempt to slow growth by making it more difficult to purchase equities on margin, and a general perception that global markets have been overdue for a correction.
North American managers managed to close the month up nearly 1% on average. Furthermore, the unravelling of carry trades, led by the Bank of Japan’s rate hike on 21 Feb, also shrank liquidity in emerging markets, particularly in Asia. While this is not entirely reflected in the performance of the respective regional hedge fund indices in February, which posted decent gains for the month, anecdotal evidence suggests that the month’s gains have been higher for the first three weeks. For instance, the MSCI World Index had gained nearly 3% for the month before finishing with a 0.5% loss. The graph below offers a snapshot of the previous two months’ performance of hedge funds across regional markets.
Eurekahedge Performance Indices - 2007 YTD (Regions)
Global Market Review
Global equity markets continued to rally strongly until the end of February on the back of a bull-run that lasted well over six months. The markets were overdue for a correction and merely needed a trigger (or a set of triggers) to set it off. In the US markets, this came in the form of the former Fed Chairman Greenspan’s comments on 26 February that a recession in the latter half of 2007 was possible. News reports of an assassination attempt in Afghanistan on US Vice-President, Dick Cheney, compounded the adverse effect on the markets. The S&P500 shed 2.2% for February, while the Nasdaq was down 3.7%.
In China, the Shanghai Composite Index lost 8.8% on the last day of February alone, amidst rumours of tightening regulation on the hot money that had been driving the index to record highs. These were sufficient reasons for investors to secure profits from the recent extended run-up in global equities, and the correction spread to other emerging markets and Europe. For instance, the FTSE 100 finished the month down 0.5%.
In the bond and interest rate markets, weaker US economic data drove prices higher in February. Prices rallied strongly on 27 February on ‘flight to quality’ trades owing to the severe correction in equities. This kept the yield curve inverted as 10-year yields shed 24 basis points to 4.57% and the 2-year note shed 28 basis points to 4.65%.
As interest rate expectations were revised sharply lower and risk levels rose towards end-February, carry trades with the Japanese yen as funding currency were unwound and, as a result, the JPY appreciated by over 2% against the USD. This was on the back of nearly three months of a strong depreciating trend, because of the speculation surrounding the G7 finance ministers’ meeting and the Bank of Japan’s monthly meeting, both in February. The euro also gained against the USD, given a possible rate hike in March by the European Central Bank (ECB) and weak US economic data.
In the energy markets, crude oil prices moved up from US$58 to $62 over the month, driven by colder weather and falling inventories in the US. Geo-political tensions also played a role in the price rise as Iran, OPEC’s second largest oil producer, could be facing tighter sanctions owing to its decision not to suspend its uranium enrichment programme.
As a result of these sharp reversals across markets, CTA and directional macro strategies had a rough month, posting negative returns of -1.6% and -0.4% respectively. But these two strategies, together with equity long/short (+1%), whose performance during the first three weeks of February disguised losses made in the last two days, are the exception. Most global hedge fund strategies had a very positive month in February, as shown by the graph below. Managers benefited from the rise in volatility, an active M&A calendar and profitable situations in the distressed debt and high yield spaces.
February returns from North American hedge fund managers remained positive across strategies despite the month-end correction in equities; the Eurekahedge North American Hedge Fund Index was up 0.8%. Most strategies returned upwards of 1% for the month, as shown in the graph below.
The best return came from distressed debt managers (+3%) as the high yield market remained strong in February, posting returns upwards of 1% for the eighth consecutive month. Though corporate bonds had been steadily appreciating, the sharp month-end equity correction spurred selling pressure in the corporate debt market. Credit spreads widened and equity market volatility spiked. These market movements proved beneficial for distressed debt, fixed income (+1.1%) and arbitrage (+0.9%) players. Also, given the worse-than-expected default data in the sub-prime lending market, special situations players in general found profitable plays in asset-backed securities secured by sub-prime mortgages.
February remained active in M&A and, coupled with new issuance activity in the convertibles space (16 deals raised US$8.8 billion in the US, while globally over US$17 billion worth of new issues were priced), this ensured a good run for event-driven managers (+2.1%).
Eurekahedge North American Hedge Fund Index
European equities fell sharply towards the end of February, giving back most of the returns made until the last few days of February; the FTSE Europe index closed the month down 2.1%. As a result, long/short equities managers ended the month nearly flat (+0.3%), with losses primarily driven by the fall in the managers’ long portfolios.
On the positive side, European convertible valuations were steady in February. Secondary trading was also driven by M&A with a share exchange offer on Beni Stabili, and rumours on Anglogold, Scottish & Southern and EMI. New issues picked up with new deals in Risanmento, IVG, Immofinanze and Aldar. In particular, Aldar’s US$2.5 billion deal was well received and traded six points up post issue. Amidst this backdrop, European arbitrage (+1.2%) and event-driven (+1.8%) managers had a terrific month.
So too did fixed income managers (+1.3%) as European bonds rallied sharply on weaker equities, benign inflation readings and comments emanating from the US about the possibility of a recession in the latter half of 2007.
CTA / Managed Futures
Eurekahedge European Hedge Fund Index
The Eurekahedge Japan Hedge Fund Index had its third consecutive month of healthy returns, with February returns at 0.9%. The month’s performance was broad-based with all component strategy indices returning close to or upwards of 1%.
Japanese equities managed to retain a portion of the gains made during the earlier part of the year, as the Topix finished February up 1.8% (though the index gave it back during trading on 1 March). Small caps were more strongly affected by the global decline in equities, as evidenced by the 3.1% drop in the Jasdaq index for February. Pre-downturn, stronger-than-expected corporate results for Q3 of the financial year and an improvement in the macro-economic fundamentals, offset concerns over the 25-basis-point interest rate hike (to 0.5%) by the Bank of Japan on 21 February. As a result, long/short players still managed to close the month at reasonable gains of 0.8%.
Japanese event-driven managers, on the other hand, were the best performers for the month at returns of 7.3%. Price anomalies in connection with the public offering of stocks and the rebalancing of Topix, continued to offer profitable trading opportunities in February.
The correction in Asian equities, Chinese equities in particular, in the last few days of the month was one of the key catalysts in the global equity market downturn. The Shanghai Composite Index lost 9% on 27 February, amidst rumors of tightening regulation on “hot money”, implying a reduction of liquidity in the Chinese markets. Markets in India (-8.4%), the Philippines (-4.8%) and Hong Kong (-2.3%) were the worst hit. Despite the dramatic sell-off, the Eurekahedge Asia ex Japan Hedge Fund Index closed the month at a modest gain of 1.2%. But what is more interesting is the performance of the Greater China component of the index: +3.1% for February. This reflects the outperformance of small- and medium-cap stocks against largecaps. Also, the Taiwanese and A-share markets did better than Hong Kong; the former owing to cheap valuations and the latter owing to being insulated from international portfolio flows.
The Korean component of the index also posted solid gains during the month (+3.4%), as the KOSPI rose 4.2% on strong performance in financials, heavy industries, energy and materials.
In the Australian markets, managers capitalised on the interim reporting season and the attendant volatility. There were also a number of security issues during the month, including the successful placement by Valad Property Group to invest in European property assets.
February was a busy month for Indian companies announcing global acquisitions as well. Some examples are Tata Steel’s winning bid (of US$12 billion) for Britain’s Corus plc; Hindalco Industries’ US$3.4 billion deal for US-based Novelis; and Suzlon Energy’s (India’s biggest wind-turbine manufacturer) announcement of a US$1.7 billion offer for a German competitor, REpower Systems.
Given the strong deal flow in the region as illustrated above, it comes as no surprise that event-driven managers posted the best returns for the month at an impressive 4.5%. Returns from long/short funds, on the other hand, mask the losses taken in the last two days of the month, at least in some of the region’s markets.
Relative value was the only strategy that bucked the general trend and posted negative returns (-2.3%) for the month. This was owing to movements in the currency markets, as ‘carry’ currencies such as JPY appreciated suddenly.
Eurekahedge Asia ex Japan Hedge Fund Index
Latin American funds registered a net gain of 1.2% in February, on average, with all component strategy indices posting healthy gains for the month.
As Latin American equities followed the declines in China and fell by almost 8% in dollar terms in one day, long/short managers in the region finished February at modest gains of 1.4% (modest compared to monthly returns for the four months before February – all upwards of 2%).
New issuance activity in the region continues at a steady pace. The year to date has seen seven companies successfully place public offerings, including a US$800 million market-cap electricity generator in Argentina, Pampa Holding. This explains the performance of event-driven managers in the region.
Eurekahedge Latin American Hedge Fund Index
In closing, the last few days of February marked the end of an equity market run-up that started in mid-2006. While the resulting spike in volatility and risk aversion may take some time to unwind, we view this is as a short-term correction, just as was the case in mid-2006. With one key difference, however; that this correction was not fundamentals-driven, whereas the 2006 decline was spurred by a major reversal in US interest rate expectations.
From the perspective of hedge funds, the spike in volatility and M&A activity should drive valuations and offer profitable entry points, especially as market fundamentals for a number of emerging economies continue to look healthy.
For instance, investors in Latin America are concerned about potential policy measures to slow the economic growth of China, as this would in turn have negative effects on the price of industrial commodity prices. Coupled with rising risk aversion by investors globally, this would likely mean that discount rates on investments in Latin America would rise, causing asset prices today to fall. This is a positive development for hedge funds in the region because it leads to indiscriminate selling and mis-pricing of some assets, and can be taken advantage of on the long or short side.
1 Based on 42.8% of the NAV for Feb 2007 as at 13 Mar 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.