After a difficult August, hedge funds did a virtual about-face in September – the composite Eurekahedge Hedge Fund Index rose an impressive 3.8%1, its best showing in over 12 months – as the Federal Reserve took a pro-active stand against risk aversion and dwindling liquidity in the markets, and cut its Fed Funds rate by a larger-than-expected 50 bps mid-month. This triggered a global rally in the equity markets (the MSCI World Index was up 4.6% for the month) and tightened credit spreads.
This boost to risky assets is reflected in the regional performance of hedge funds for the month, as shown in the graph below – Asia ex-Japan re-assumed its position as the best-performing region for hedge fund assets, at a whopping 6% returns for September alone. That said, returns during the month were robust across the board save Europe, where equities could only marginally recover losses made earlier in the month owing to the credit market turmoil (the FTSE Europe Index ended the month up 0.7%).
Global Market Review
In anticipation of a 25 bps cut in the Fed Funds rate, and following a larger-than-expected 50 bps cut, equity markets staged a global rally (more pronounced in riskier emerging market equities) in the latter half of September; the MSCI World Index rose 4.6%, while its emerging markets component was up a substantial 10.9%.
The commodity markets, as indicated by the Reuters CRB Index, rose over 7% through the month, adding to inflationary concerns. Crude oil ended the month at a high of US$80/barrel, owing to supply disruptions in Mexico, a lesser-than-expected output increase by OPEC, and steeper-than-predicted declines in US inventories. Gold bullion also reached a multi-decade peak of US$774/oz following the Fed announcement.
In the fixed income markets, the yield curve generally steepened and credit spreads tightened. However, credit spreads of low quality US bonds widened from 2.8% to 4.6%, as also yield differentials between inter-bank and central bank rates (with the former trading at a premium to the latter), owing to lack of clear guidance on participants’ risk exposure.
And lastly, in the currency markets, the US dollar weakened significantly against most major currencies, as the markets anticipated further rate cuts from the Fed in the coming months.
These broad market trends provide the basis for explaining the performance of various hedge fund strategies during August (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.
Hedge funds in North America had a solid month in September; the Eurekahedge North American Hedge Fund Index advanced by 3%. In the underlying markets, equities ended the month sharply positive (S&P 500 was up 3.6% while the DJIA rose 4%), with most of the month’s gains coming in the latter half of the month, after the rate cut by Fed on 18 September. Despite rallying equities, bonds in the region did well too – yields on the 10-year Treasury note, after seeing wide swings during the month, closed up 4 bps, while yields of the 90-day Treasury bill declined nearly 30 bps. However, following the interest rate cut, the dollar further declined against most major global counterparts (-4.7% vs the euro; -0.8% vs the yen), while commodities such as gold and oil, among others, did extremely well during the month (gold touched its 28-year high while crude oil rose over 10%).
Amidst such movements, long/short managers returned 3.1%, largely benefiting from long positions during the month, with investments in sectors such as energy faring notably well. CTAs were up an impressive 5.7% as commodity-linked trades, coupled with short US dollar positions (against the euro, Canadian and Australian dollar) proved profitable during the month. Fixed income managers (1.3%) benefited from favourable movements across the bond markets, which did considerably well; and distressed debt managers were up 1.9%, as shorting collateralised debt obligations and asset-backed securities, among other things, proved profitable. Event-driven managers finished the month up, with returns averaging 1.2%, as the M&A and LBO financing markets gained momentum, and saw the successful completion of many large transactions during the month (such as the LBO of First Data Corporation, for instance). Arbitrageurs and relative value players returned 1.4% and 1.8% respectively, benefiting partly from pair trades in currencies, while multi-strategy managers, with most trading styles faring well, ended the month up 1.5%.
Eurekahedge North American Hedge Fund Index
European hedge funds fared flat to positive in September, with the Eurekahedge European Hedge Fund Index advancing a mere 0.3%. The month, in the underlying markets, began with difficult conditions, as the global credit crunch continued to make its presence felt in Europe, causing equities to slide about 3.5% intra-month. The Bank of England was forced to intervene to infuse liquidity into the markets, and particularly into Northern Rock, a retail mortgage bank, which was compelled to take an emergency loan (from the BoE) in order to remain solvent. However, post the Fed’s rate cut, the situation eased, with stocks sharply rebounding – the FTSE 100 finished the month up 2.6%, benefiting long/short managers, who returned 0.3% for the month. The underperformance of the strategy, though, was partly because healthy intra-month gains from short positions in credit sensitive stocks, which fell about 10-20% by mid-month, were sharply reversed as they (unexpectedly) rallied strongly during the latter half of the month.
Fixed income managers, ended the month absolutely flat, as the weakness in the markets during the first half of the month, was reversed towards the month end, as, despite rallying equities, bonds markets did well (owing to significantly tighter credit spreads, among other things). CTAs posted impressive returns (6.8%), owing to the strong gains in commodities during the month, as well as sharp appreciation in the euro (closing 4.7% up against the US dollar). Multi-strategy managers fared well too, returning 0.9%, as equities, bonds and FX posed some opportunities for them to profit from.
Arbitrage funds recorded returns averaging -1.2%, as statistical arbitrage (based on ‘systematic statistical analysis’) worked negatively for one of the index constituents, drawing the average into negative territory; the rest of the funds finished the month more or less flat. Likewise, the Eurekahedge Europe Event Driven Hedge Fund Index declined 2.5%, with one activist-investing manager (that returned <-20%) negatively skewing the strategy’s average; the returns for all other European event-driven funds averaged 0.3% for the month.
Managers in Eastern Europe & Russia, however, registered healthy returns, with the Eurekahedge Eastern Europe & Russia Index up 3.5%. This was partly owing to positive economic data in the region such as rallying commodity prices (led by gold and oil), attractive Russian GDP growth (due to acceleration in the services sector), easing liquidity conditions (with overnight money market rates falling below 5% in Russia), and a healthy appreciation in the Turkish lira against the US dollar (7.2%).
CTA / Managed Futures
Eurekahedge European Hedge Fund Index
Managers in the region posted decent gains (relative to other regional fund allocations), as the Eurekahedge Japan Hedge Fund Index advanced 1.1% in September. Markets in the region, with support from the Fed’s rate cut around mid-September, rallied strongly (though not as much as markets in many other regions), making good their intra-month losses. The Topix as well as the Nikkei 225 rallied about 7% from their month’s lows, to close up 0.5% and 1.3% respectively. Sectors such as basic raw materials and infrastructure development, with high demand from India and China, did well during the month while sectors dependent on the domestic economy, technology stocks and banks – which suffered due to diminishing expectations of an interest rate increase – underperformed over the month. These market movements generally proved profitable for equity long/short managers during the month (1.1%).
The yen closed up (0.8%) against the US dollar, but ended considerably down against other major counterparts, such as the euro, the Australian and New Zealand dollar. These currency trends coupled with the gains in commodities and commodity-related stocks, helped CTAs to some extent in returning an impressive 2.1% for the month. Multi-strategy managers fared well too, returning 1.6%, on the back of the overall healthy performance of investments across most strategies in the region. Event-driven funds were up 4.5%, with one manager (that exploits market inefficiencies, index rebalance and special situations regionally) widely skewing the strategy’s average
Eurekahedge Japan Hedge Fund Index
Asia ex-Japan was one of the best performing regions last month, as the Eurekahedge Asia ex-Japan Hedge Fund Index advanced 6.1%. This performance came amidst soaring equity prices coupled with the strengthening of domestic currencies against the US dollar, and strong investor sentiment.
China-focused hedge funds were one of the best performers during the last month, as they returned an impressive 8.5%, advancing returns in the country for three quarters of the year to a whopping 54%. During the month, domestic markets proved resilient to the rise in inflation (which touched a 10-year high), as companies (mainly in the steel, building material and transport sectors) reported profits of over US$200 billion (37% higher than the last year), for the first eight months of the year. The H-shares Index advanced 22% during the month, mainly in anticipation of large inflows from mainland Chinese investors directly into the Hong Kong markets (as was announced by the government in August, which however, was still not implemented). Amidst such strong rallying markets, coupled with a number of IPOs in the region, long/short managers returned 8% while multi-strategy managers returned in excess of 10% for the month.
Likewise, Indian hedge funds returned 9.8% in September, on the back of rallying domestic markets. The BSE Sensex rose an impressive 12.9% during the month, with strong inflows from FIIs, and the Indian rupee strengthened significantly against the dollar, making it one of the best-performing Asian currencies in September. Long/short managers in the region, benefiting from soaring equities, gained 10%, while multi-strategy managers returned 10.7% during the month.
The Eurekahedge Australia/New Zealand Hedge Fund Index increased in value by 2.6%, with healthy contribution from long/short, CTA and event-driven players. Long/short managers returned 3.4%, making healthy gains from equity markets (ASX was up 5.3%; NZX rose 3.6%), while event-driven managers benefited from special situations in the corporate arena, such as the announcement of the US$4 billion merger of Adelaide Bank and Bendigo Bank, for instance. CTA managers made impressive gains, averaging 6.1%, by exploiting opportunities among commodities as well as currencies (the Australian and New Zealand dollar gained 8.5% and 7.7% respectively against the US dollar) in the region.
Hedge funds in Korea posted relatively modest returns of 1.1%, during the month, benefiting from healthy performance from equities (KOSPI was up 3.9%) and positive economic data such as good sales, exports and industrial growth.
CTA / Managed Futures
Eurekahedge Asia ex-Japan Hedge Fund Index
Latin American hedge funds posted relatively modest returns (compared to their usually above-average returns) in September, with the Eurekahedge Latin American Hedge Fund Index returning 1.6%. This was despite rallying domestic markets and strong regional economic data, which to some extent, were a result of the reduction in interest rates in the US around mid-month.
Long/short equity managers returned 1.9% for the month, while the MSCI EM Latin America Index advanced 12.4%. This was largely because only a small number of stocks (some of which being commodity stocks) led the equity-rally, while most others, struggled during the month. Secondly, a number of managers bought into liquid stocks (particularly in Brazil), most of which largely underperformed during the month, thereby taking a toll on the average returns in the region. Macro funds registered decent returns of 0.8% on the back of positive economic data emanating from the region – appreciation of the real against the US dollar (up 6.9%) in Brazil, and higher oil prices, modest inflation and a mortgage boom (due to stable interest rates) in Mexico. Fixed income funds returned 1.1% for the month, owing to favourable interest rate trends in the region, and multi-strategy managers finished the month up 1.5%, benefiting from movements across equities, interest rates and FX. Event-driven funds registered returns averaging -0.3%, with one index constituent negatively skewing the average, owing to its exposure to pair trades in the mining and transportation sectors.
Eurekahedge Latin American Hedge Fund Index
After arguably one of the best months in the past 12 months, our outlook for hedge fund performance in the coming months remains strongly positive on several counts. For one, the weakening dollar translates to a rise in the likelihood of foreign acquisitions, as US assets have become more attractive to foreign investors. Secondly, with the return of liquidity, the substantial pipeline of underwritten leveraged loan and high yield bond debt on investment banks’ books has gradually begun to trickle back into the markets, affording profitable opportunities for skilled managers in the coming months. This is also generally true of most assets that have taken a hit during the market turmoil of the past few months. Weaker-than-expected 3rd quarter earnings reports announced by most major investment banks in early October have also raised interest levels among bottom-trawling investors.
That said, there are still a few risks looming on the macro-economic horizon – the revised (now upbeat) August jobs report in the first week October together with a strongly positive September jobs report, has cast the September Fed rate cut in an inflationary (as opposed to anti-contractionary) light, and this is exacerbated by rising commodity prices. While market participants evidently expect the Fed to cut rates further, inflationary pressures in the coming months might curtail its ability to do so. Furthermore, problems persist in the US mortgage markets.
Even so, we believe that the aggressive rate cuts in September have provided sufficient impetus for a return of liquidity and healthy risk appetites to the markets, while earnings announcements for the 3rd quarter are painting a clearer picture of the extent of risk exposure among participants. Market movements during the first half of October also show increased stability and declining risk aversion.
1 Based on 66.94% of the funds reporting their Sep 2007 returns as at 15 Oct 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.