The composite Eurekahedge Hedge Fund Index advanced 1.7%1 for June, bringing returns for the first half of 2007 to a robust 9%. Despite choppy markets, the month saw hedge funds turning in healthy gains almost across the board, as inflationary pressures and continued weakness in the sub-prime mortgage market drove volatility up. One of the major market events during the month concerned losses at two Bear Stearns hedge funds in the high-yield space. These and other concerns about high yields triggered reversals in the US and European equity and bond markets. Emerging market, and more specifically, Asian equities, on the other hand, proved more resilient. These are broadly reflected in the performance of regional hedge fund mandates as seen in the graph below.
Global Market Review
Distress in the sub-prime mortgage market coupled with expectations of higher global interest rates, resulted in mixed performance in global equities; Japanese equities were up 1.5% while US and European equities were both down (-1.8% and -0.8% respectively) during the month.
In the bond markets, yields closed the month at multi-year highs despite some rallies towards the latter part of the month, driven by expectations of higher global interest rates.
In the energy markets, crude oil prices soared, boosted by supply disruptions (falling US inventories and the likelihood of labour strikes in Nigeria).
In the currency markets, as the Bank of Japan left rates unchanged on falling consumer prices and production, the yen weakened against the euro, the US dollar and Asian currencies. Trading between the euro and the US dollar was more mixed, as the dollar initially strengthened on the back of robust US retail sales but lost ground towards month-end on easing US inflation data.
These broad market trends provide the basis for explaining the performance of various hedge fund strategies during June (refer to figure 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.
Choppy markets notwithstanding (the S&P 500 finished the month down 1.8%), North American hedge funds had a good run in June (the Eurekahedge North American Hedge Fund Index was up 1.2% for the month), owing to inflationary pressures and a re-assessment of risk appetites in view of over-levered sub-prime mortgage markets. The latter have also dampened demand for new issues in the high yield, leveraged loan and corporate debt markets, and drove credit spreads wider. This and the attendant rise in volatility afforded some profitable short-term trading opportunities to long/short funds (0.8%).
Arbitrage and distressed debt managers had a modest month (0.5% each) despite rising interest rates, widening credit spreads (the high yield market was down 1.7% for the month) and a general increase in volatility in the markets. Given positive global economic data, low default rates among corporate borrowers and continued new issuance activity, the current spike in volatility levels could be short-lived. This has had the effect of discouraging investor demand for volatility exposure during the month.
Event-driven strategies still had a healthy run (1.1%) as June was a busy month in terms of equity special situations (the US$9.6 billion acquisition of Utah-based Huntsman Corp by the Dutch company, Basell and the spin-off of Tyco International into three separate arms, to name a few).
Directional macro funds (1.9%), on the other hand, were among the better-performing strategies during the month, profiting from technical and macro trends in the interest rate and currency markets. But the month’s best returns came from CTA/managed futures funds (2.9%), with metals trading (volatility exposure), refined products trading (geographical arbitrage) and oil (up 8.8%) proving profitable.
Performance in the European hedge fund space was relatively flat in June, with returns averaging 0.5% and a few strategies turning in negative returns. In the underlying markets, the sharp upward move in long-term bond yields globally, coupled with the Bear Stearns fiasco, led to a reshuffling of equity portfolios and severe profit-taking in some of the sectors, notably financials. This goes some way towards explaining the relatively flat returns of long/short managers in the region (0.5%).
CTA/Managed futures was the month’s best performing strategy in the region, with short positions in natural gas (prices fell owing to an unexpected increase in supply), and long positions in oil and metals proved profitable.
Implied volatilities in the convertible bond space were generally weaker, as investors secured some of their profits going into the summer months. New issuance in European convertibles too, at US$1.4 billion, was significantly lower in June compared to that in May (US$5 billion). This has at least partially affected the performance of arbitrage (-0.5%) and fixed income (-1.4%) managers during the month.
Markets in Japan ended the month positive after recovering from an interim correction impacted by interest rate jitters early on in June. However, the possibility of a rate hike in August is still the talk of the town despite a fall (though negligible) in the CPI (-0.1%). With small- and mid-cap stocks having outperformed the large-cap market, the Nikkei, in spite of some volatility, touched its 7-year high but declined towards the end of the month due to the fall in the US stock markets, and ended the month up 1.5% while the TOPIX returned 1.1%. As for smaller Japanese indices, the Nikkei JASDAQ and the TSE Mothers were up 2.7% and 4.8% respectively. Clearly, managers allocating to small- and mid-cap stocks as also those with long positions in select large caps earned good returns. The Eurekahedge Japan Long/Short Equity Hedge Fund Index was up 1.5%.
Relative value players in the market took the cake in June. The Eurekahedge Japan Relative Value Hedge Fund Index was up an impressive 3.5%, on the back of positive economic indicators and a depreciating yen. The yen weakened in June due to the relatively large volumes of carry trades against high yielding currencies such as the New Zealand and the Australian dollar. On the whole, hedge funds in Japan posted their best returns so far this year at 1.4%.
Asia ex-Japan markets had a terrific run in June as the MSCI Asia ex-Japan index posted gains in excess of 5%, with June being its third consecutive month of having returned over 4%. The Taiwan stock index returned upwards of 9% as the government decided to raise interest rates by 25 bps to 3.125%. Among other countries, Thai and Korean markets were up 5.3% and 2.5% respectively. The Indian stock index, however, was up a mere 0.5% as three large IPOs lapped up funds and liquidity from the market.
The Eurekahedge Asia ex-Japan Hedge Fund Index advanced 3.1% in June with good performance from multi-strategy as well as long/short equity funds. The latter was up 3.4% as managers took advantage of opportunities in Taiwan as well as China markets.
Managers benefited from entering into long-trades early on in the month in Taiwan and earning healthy returns throughout the month. On the other hand, shorts in China were highly fruitful as the markets dropped to the extent of 7% when China announced a new set of regulations facilitating cross-border investment and to bridge the gap between valuations in mainland China and Hong Kong. The buoyant M&A activity (such as H Fund, a private equity fund acquiring Shijiazhuang Pharmaceutical Group, the sixth largest Chinese pharmaceutical company) across Asia ex-Japan kept multi-strategy funds in good shape (3.7%) with best returns from the strategy coming from China (5.5%).
Latin American markets proved very resilient to the turbulence in global equities, and despite interim choppiness, the MSCI Latin America Equity Index was up 2.7% while the Ibovespa rose 3%. The month saw some very positive Brazilian macroeconomic data, and long/short managers in the region posted solid gains for the month (2%).
In the fixed income markets, despite a bigger-than-anticipated cut in the interest rates (50 bps) by Brazil’s central bank, the yield curve steepened as inflationary pressures pushed long-term yields higher. Since long-term bond yields saw a sharp up-tick globally, sovereign spreads widened too. These conditions were beneficial to fixed income managers (up 1.1%), particularly in relative value plays.
Event-driven strategies in the region continue to post decent gains (1.2%) as funds focus on domestic names such as the infrastructure-related IPO of Log-in Inc. Directional macro funds, on the other hand, were nearly flat for the month (0.3%), given heightened volatility in the equity markets and pressure on commodity prices (owing to an acceleration of Chinese inflation in May).
To summarise, we see the month’s market movements as indicative of investors taking a breather, re-assessing risk levels, moving away from the liquidity-fuelled rallies of recent months towards a more fundamentals-driven approach. In terms of macroeconomic fundamentals, not only has factory and manufacturing data been positive in recent months but consumption data also looks encouraging, especially given the 4.5% unemployment rate shown in the June employment report. The markets are also positive in anticipation of the start of the 2007 Q2 earnings season in July.
In terms of hedge fund performance we believe event-driven strategies will continue to be the mainstay given that the US$2.7 trillion worth of deals seen in the first half of 2007, is unlikely to abate. We are similarly positive about equity-focused strategies such as long/short and directional macro. As the markets seem geared for a pick-up in volatility, it would also be interesting to see how arbitrageurs and relative value players perform in the coming months.