The Eurekahedge Hedge Fund Index advanced a healthy 1.3%1 during July, even as weakness in the credit markets lowered risk appetites and triggered sharp sell-offs in equities and high-yielding currencies towards the month’s close. The ensuing flight to safe-haven assets, coupled with tame US inflation data, spurred rallies in bond prices and widened credit spreads; the MSCI World Equity Index was down 2.2% for the month, while the Citi World Government Bond Index rose 3% over the same period.
Performance among regional hedge fund managers was mixed (refer to graph below), with allocations to North America, Europe and Japan finishing the month largely flat, while allocations to the emerging markets, particularly Asia, held on to gains made earlier in the month and registered impressive returns.
Global Market Review
Global equities had a rough close to the month of July, with the MSCI World Equity Index shedding 2.2%, the S&P hitting multi-year lows after losing 3.1% and several European markets witnessing heavier declines (the DAX was down 5.3% while the FTSE lost 3.7%). Japan’s Topix Index shed 3.9%. The exceptions were pan-Asia and emerging market equities – the MSCI Asia Index and the MSCI Latin America Index were up 7.9% and 3.5% respectively – which managed to hold on to exceptional gains earlier in the month. The end-of-the-month sell-off was precipitated by lowered risk appetites, as heightened concerns about the impact of US subprime market woes on the broader economy.
As a corollary effect, bond prices rallied and credit spreads widened amidst heightened risk-aversion and the search for quality assets. The lowered risk appetites also spurred sell-offs in high-yielding currencies, unwinding yen-funded carry trade positions and strengthening the Japanese yen against most major currencies, such as the Australian dollar, US dollar and euro. The US dollar also appreciated on the back of flight-to-quality investing.
In the energy markets, falling US inventories drove crude oil prices to a record high (US$78 per barrel), while natural gas prices were pushed downward as cooler climes returned.
These broad market trends provide the basis for explaining the performance of various hedge fund strategies during July (refer to graph below). A detailed, region-wise analysis of the underlying factors driving the month's returns is taken up in the following sections of this write-up.
North American hedge funds were largely flat in July (the Eurekahedge North American Hedge Fund Index was up 0.2%), as news of various financial institutions facing difficulties linked to weakness in the subprime mortgage market, triggered sharp reversals in most financial markets towards the month’s close: a re-pricing of credit risk, plunging equity prices and rallying bond prices. Amidst this heightened volatility almost across the board, the performance of hedge fund strategies in the region was mixed, with short transactions either contributing to profits or offsetting bigger losses.
Fixed income managers turned in the best returns for the month (2.7%), with tactical shorts in the US subprime mortgage markets contributing significantly to returns. CTAs also made decent gains (0.8%) with profitable longs in metals trading as robust Asian demand, potential supply shortages and significant M&A activity (in the mining and oil service sectors, for instance) supported prices. Global M&A activity was robust in general, with US$506 billion worth of deals announced during the month, providing several merger arbitrage opportunities during the earlier part of the month. Event-driven strategies ended the month marginally up (0.2%). Multi-strategy managers too were mildly positive (0.3%), as short-term trading strategies profitably exploited the heightened volatility in the equity, bond and currency markets towards the month’s close.
The main loss-making strategies in the region were arbitrage, distressed debt and relative value, as the high yield market dropped 3.1% to reach record lows, and high yield bonds, structured mortgage products and credit derivatives all moved sharply lower.
Hedge funds in Europe recorded relatively flat returns for the month of July, with the Eurekahedge European Hedge Fund Index down 0.3%. This was mainly due to tremendous turbulence across the European markets during the month, on the back of a weak market sentiment on account of worries centred on subprime lending in the US.
European equities, like many other markets, started the month strong, but fell dramatically towards the second half of the month, closing considerably down (FTSE fell 3.7% while DAX lost 5.3%) owing to rising risk aversion and wider credit spreads. This goes some way in explaining the negative returns of long/short equity managers, which ended down 0.7% for the month.
On the other hand, CTA managers were the highest gainers across Europe, as the Eurekahedge Europe CTA/Managed Futures Hedge Fund Index was up 4.5%, while multi-strategy managers gained 1.3% for the month. The former benefited strongly from surging oil (which rose 10% for a second month in succession) and metal (which also fared well across the board) prices, while the latter made gains from the volatility in the markets as well as from directional currency trends (the euro touching its record high against the US dollar) and interest rate (which rallied in Europe in reaction to negative credit news) during the month.
July was a decent month for hedge funds in Japan; the Eurekahedge Japan Hedge Fund Index ended the month flat (-0.1%) despite choppy markets, mainly towards the latter part of the month, due to increased US subprime concerns.
Japanese long/short equity funds returned 0.5% for the month, benefiting mainly from their short positions. However, some gains were also made from long positions as companies (in sectors such as technology) reported good Q2 earning results. Japanese equity markets saw a decent start to the month, but declined sharply towards the latter part of July as the yen appreciated rapidly against major currencies, touching its 3-month high against the US dollar and euro, and gaining 2.3% against the Australian dollar. The effect of another global credit scare, which triggered a sell-off in US equities and in turn rubbed off on global markets, took its toll on the Japanese equity indices (Nikkei was down 4.9% and TOPIX slid 3.9%).
Bonds in Japan, on the other hand, with an anticipated interest rate hike not materialising, rallied strongly (over 3%) during the month, which coupled with the yen movements brought about opportunities for multi-strategy managers across Japan; the Eurekahedge Japan Multi-Strategy Hedge Fund Index ended the month up 1.7%.
July was a healthy month for managers allocating to Asia ex-Japan with the Eurekahedge Asia ex-Japan Hedge Fund Index returning an impressive 5.4%. This was due to the resilience shown by emerging Asian markets towards the continued problems in the US subprime mortgage markets, which in the latter part of the month, caused tremendous turbulence across the globe. The MSCI Asia Pacific ex-Japan Index ended the month up 4.6%.
Managers allocating to China returned 8% in July, benefiting from robust growth across the markets. The Shanghai Composite Index returned a whooping 17.7% and the H-shares (benefiting from the broadening of the QDII programme) returned 11.2%, benefiting long/short equity managers (mainly from long positions), which returned 7.1% for the month. Multi-strategy managers registered gains averaging 9.8% as the rallying equity markets, strong liquidity inflows from foreign investors and a rise in interest rates posed some lucrative investment opportunities for them in the region.
Hedge funds in Korea and Taiwan reported returns of 2.1% and 4.8% respectively as Korean managers benefited from an increase (in excess of 11%) in the Seoul Composite Index as well as from a hike in interest rates, as the Bank of Korea raised the overnight call rate to 4.75% (in view of strong economic data such as robust sales of ships and machinery, and an increase in the PPI). In Taiwan, the Taiwan Weighted Index was up 4.3%, giving managers – particularly long/short managers – good trading opportunities during the month.
Managers allocating to India fared well in July, with strong gains coming from long/short equity managers (3.9%), as the BSE Sensex, though volatile, rallied 5.9% during the month. On the other hand, managers invested in Australia/New Zealand ended the month flat to negative (-0.3%) with trend-following styles of investing taking a hit, as, among other factors, commodity-based currencies such as the Australian and New Zealand dollar declined from their multi-year highs on the back of pressure from unwinding of carry trades.
Hedge fund managers allocating to Latin America had a good month this July, with returns averaging 1.8%. The month, in the underlying markets, looked good until its last week when the deterioration of the US mortgage securities markets caused an erosion of over 10% of Brazil’s Ibovespa’s value in just around four days’ time and drove credit spreads (normally thin across the region) wide. The MSCI Latin America Index (which also tumbled 10.2% in four days) ended the month up 1.3%.
Despite high volatility across equities, long/short equity managers benefited from healthy markets across regions such as Brazil, Mexico and Colombia. The Eurekahedge Latin America Long/Short Equity Hedge Fund Index returned 2.6% for the month, with managers benefiting from both long and short positions.
Macro and multi-strategy managers too registered healthy gains of 1.8% and 1.3% respectively. As for the former, comfortable GDP growth, under-control inflation, healthy FDI investments, higher-than-targeted government’s tax revenues and above all, a fairly strong Brazilian real (up 2.4%) went some way in keeping them healthy, while high short-term volatility and FX trading, among other factors, kept the latter in good shape.
The last week of July witnessed sharp corrections across most financial markets amid concerns over leverage and contagion. What this implies for the markets is a re-pricing of risk, higher borrowing costs, widened credit spreads and heightened equity and credit volatility. It remains to be seen what further impact weakness in the credit markets would have on the broader economy, but one key risk is that of a liquidity crunch. That said, global economic growth remains healthy, with strong earnings and low unemployment rates. The outlook for global M&A activity remains strong despite steeper borrowing costs, as companies continue to boast strong free cash-flow yields. Meanwhile, recent calls for the Federal Reserve to lower rates may also prove helpful.
As for hedge fund performance in the coming months, we remain positive at least with respect to specific strategies. For instance, the outlook for convertible arbitrageurs is particularly bright, given wider credit spreads, higher equity volatility and cheaper valuations. Value traders can profitably exploit the pick-up in volatility, while equity-focused strategies, both opportunistic and directional, can enter the market at lucrative prices.
1Based on 48.02% of the funds reporting their Jul 2007 returns as at 13 Aug 2007.
2The Eurekahedge Japan Hedge Fund 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.