May spelled yet another good month for most hedge fund strategies, as the composite Eurekahedge Hedge Fund Index returned a solid 2.5%1 on the back of soaring equities, abundant liquidity in the markets, a still-buoyant M&A landscape, and positive economic and corporate earnings data.
Region-wise, North American managers posted healthy gains (2.1%) but the month’s best returns came from funds allocating to the emerging markets (4.4%), notably in Asia ex-Japan (4.9%), with the underlying markets proving particularly resilient to negative data. Performance among European strategies, on the other hand, was more varied and this is reflected in the relatively subdued returns of the Eurekahedge European Hedge Fund Index (1.3%). This may be attributed to, among other things, some volatility in European equities early in the month and weakness against the US dollar (as the markets braced themselves for a more extended tightening cycle from the European Central Bank). A more detailed comparison of regional funds’ performance in recent months is presented in the graph below.
Global Market Review
Amidst a stable ‘more of the same’ scenario, global equities got a further boost in May from increased M&A activity, stronger-than-expected US economic data and no dearth of liquidity; reflecting this, the MSCI World Index rose 3.4% during the month.
Positive economic data emanating from the US led to diminishing expectations of an interest rate cut in the future and bond prices witnessed an overall downward trend during the month, pushing US 10-year yields up to a high of 4.89%. Strong economic growth in Europe and Asia also precipitated a similar trend in respective regional bond prices.
In the energy markets, easing conditions on both the demand (rising inventories) and supply (tensions in Nigeria seem set to abate) fronts meant that crude oil, natural gas and gasoline all finished the month lower. Metals prices traded lower as well, owing to more stable demand and supply conditions and to a strengthening dollar.
And lastly, in the currency markets, the US dollar strengthened on the back of better-than-expected economic data and continued emphasis on inflation from the Fed. Furthermore, the resulting higher US interest rate expectations, coupled with a hawkish European Central Bank and Bank of Japan’s decision to keep rates unchanged at 0.5%, spelled a widening interest rate differential; the US dollar strengthened against both currencies, while the euro reached record highs against the Japanese yen.
These broad market trends provide the basis for explaining the performance of various hedge fund strategies during May (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.
US equities powered forward for a third consecutive month (the S&P500 was up 3.3%, while the DJIA advanced 4.3%) as themes that kick-started the rally continued to hold sway (improving economic growth, earnings growth, pause in rate hikes) and the markets ignored negative news (such as continued weakness in home sales data).
M&A volume drove prices in both the equity and fixed income markets. Amid such clear up-trends, the Eurekahedge North American Hedge Fund Index returned a strong and broad-based 2.1% for May. Equity long/short (2.3%), event-driven (2%), macro (1%) and multi-strategy (2.1%) funds were the obvious beneficiaries of such clear trends.
Although this is not the typical environment for arbitrage and relative value players, the surge in equity prices meant an increase in hedging activity among market players, in the form of put options and more specifically convertibles. Also, participants in the convertibles space benefited from the high volume of new issuance activity (US$12.4 billion in domestic convertible bond issues were priced during the month).
Furthermore, bullish sentiment in the past two months meant that there were a decent number of sectors/stocks that were oversold. As a result, volatility remained at stable levels, and arbitrage (1.1%), relative value (1.7%) and distressed debt (0.9%) managers in the region had a healthy run during the month.
Returns from these strategies in recent months are compared in the graph below.
European equities too rose handsomely in May, with major regional equity indices such as FTSE and DAX at multi-year highs, as strong economic growth and rising confidence in the region drove prices higher. This is naturally reflected in the performance of equity long/short funds (1.6%) in the region.
Event driven was another of the better performing strategies during the month (1.5%), given the rise in M&A activity, particularly in the banking and utilities sectors (ABN Amro, Societe Generale, E.On being some of the prominent names).
Coupled with the release of strong GDP data, the interest rate hike in the UK and signals of further monetary tightening by the European Central Bank led to a fall in debt prices and weakening of the euro. Currency trading was not as profitable in May, with losses coming in from long-euro positions. These factors have somewhat dampened the overall performance of European hedge funds during May, as reflected in the relatively modest 1.3% returned by the Eurekahedge European Hedge Fund Index for the month.
Japanese equities rallied towards the end of the month, bringing the Nikkei 225 (2.7%) and the TOPIX (3.2%) indices to a positive close for May. However, investor focus was limited to the large-cap stocks, as the mid- and small-cap indices registered flat to negative returns for the month (the TSE Mothers index fell 5.5%). As a result, equity long/short managers allocating to Japan posted healthy, albeit relatively modest, returns of 1% during May.
The main drivers of the month’s rally were a better-than-expected reporting season, positive economic data (falling unemployment rate, rising consumer spending, etc) and a weakening yen. M&A activity too remains buoyant; for instance, Fujitsu is acquiring the minority stakes of three of its subsidiaries. Among fund managers in the region, relative value players took the most advantage of these conditions, rising a healthy 1.9% for the month.
Overall, hedge fund returns during the month were dampened by the fact that the best equity market performers were concentrated among the large-cap names while the smaller indices were actually down. The Eurekahedge Japan Hedge Fund Index finished the month up 0.9%.
For the third month in a row, Asia ex-Japan contributed the most to hedge fund returns globally; the Eurekahedge Asia ex-Japan Hedge Fund Index advanced a whopping 4.9% in May. Again, these returns were also broad-based, with strategy-wise returns upwards of 1% almost across the board.
To reiterate what has been mentioned elsewhere in the write-up, market movements during the month were, for the most part, a continuation of those in April – strong corporate earnings data, ebbing inflation concerns and an influx of liquidity – coupled with the concentration of emerging market opportunities, explain hedge fund returns in the region. Taking a closer look at some of the region’s key equity markets:
In China, regulatory measures were stepped up in an effort to dilute speculation in the markets (such as tripling the stamp duty, raising the interest rate, etc ). Although this resulted in a 6.5% fall in China’s A-share market, it proved to be a mere blip as equity prices rebounded strongly to close the month up 7%. Also, unlike in February, this “blip” had little effect on other markets in the region or otherwise.
Indian equities, on the other hand, repeated their April performance by rising another 6.5% in May on the back of a strongly positive results season. In Australia too, the ASX 300 rose 2.6% in May, with M&A deal flow continuing at a high rate. In Korea, improving external (strong exports) and internal (industrial production) macro-conditions lent support to a continued rally in equities; the KOSPI rose 10.3% for the month.
The Eurekahedge Latin American Hedge Fund Index posted a robust and broad-based return of 3.1% for May, as regional equities rallied on the back of strong earnings reports, expected earnings growth and capital inflows. The Brazilian equity index, Ibovespa, rose 12.8% (in US$ terms) in May. The region is also no exception to the global theme of buoyant M&A activity, with both Chile and Brazil witnessing consolidation in the retail sector. As a result, and in line with global trends, this market environment was conducive for most related strategies such as long/short (3.5%), directional macro (4.6%) and event driven (1.5%).
To summarise, market movements and hedge fund returns in May were largely a continuation of those seen in April, as M&A volume and large capital flows provided the fuel for a global equity rally kick-started by strong earnings data. Also of note is the resilience to negative news that several of these markets have shown over the past few months.
While the strong economic growth and rising confidence in markets such as China, India, Korea, Germany, France and Italy, can explain the growth (current as well as expected) to an extent, asset valuations do seem stretched. A key risk in the current environment is that of a possible market correction, brought on by Fed tightening or merely by profit-taking. Furthermore, such a correction could be exacerbated by an unwinding of carry trades, as was seen in February. The if’s and when’s of this are anybody’s guess, the structural soundness of the underlying economies notwithstanding. Fund managers are, nevertheless, pricing this risk into their near-term outlook.
1 Based on 65.69% of the funds reporting their May 2007 returns as at 18 Jun 2007.
2 The 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.