Eurekahedge's Monthly Roundup: North American Hedge Funds, April 2006

Jun 30 2006 | 3:30pm ET

By Rajeev Baddepudi, Eurekahedge

Introduction North American hedge funds have actually turned in the best (or rather the least negative, at -0.6%) returns among all the regional sub-indices, in a month that saw all the regional indices in negative territory. Looking at the breakdown of these returns by strategy, it is clear that equity long/short (-1.9%) and macro (-1.6%) funds were the major contributors to the month's dip.

The magnitude of the pullback (the S&P 500 and NASDAQ returned -6.5% and -3.1% respectively), the risk aversion implied by heightened volatility, and the fact that small-cap stocks were hit worse than large caps (the returns of the Russell 2000 Value and Growth Indices were -4.14% and -7.04%, respectively), all seemed to have conspired against these two strategies in the North American markets.

Market Overview Fears over inflation (mainly attributable to the recent extended rallies in commodity prices, and exacerbated by uncertainty over the direction of the Fed's monetary tightening policy) precipitated the turnaround in the financial markets. The Fed's rate hike on 10 May may well have sparked off the downturn, and the markets are wary of future expectations. Global equities witnessed a heavy sell-off, with the MSCI World Equity Index falling 3.4% for the month. Given the recent liquidity-fuelled rallies and excessive speculation seen in emerging market equities, it should come as no surprise that the drop in equity prices was proportional to the riskiness of the asset: the S&P 500 posted a loss of 6.5% for the month while emerging market indices such as the MSCI EM Latin America (-14.2%) and the MSCI EM Eastern Europe Index (-16.6%) registered far steeper declines.   In the commodity markets, while precious metals were hit by the reversal in trends and energy prices were range-bound, base metals, notwithstanding the intra-month volatility, continued to be plagued by supply concerns while demand remained robust. As a result, base metal prices registered strong gains (copper prices, for instance, rose 13%) for the month, and the composite CRB-Reuters Commodity Index was flat at 0.7%.

Interestingly, however, lowered risk appetites did not translate into rallies in the treasury market, which continued its sell-off as 10-year yields rose a modest 5 basis points to 5.11% and 5-year yields rose 11 basis points to 5.03%. One possible explanation for this is that the leverage deployed by hedge funds seems to be lesser than in the past, implying limited impact on fixed income markets. The yield curve continues to be relatively flat in the absence of any clear indications from the Fed regarding its next move in tackling inflation.

And lastly, in the currency markets, the significant fall in the US dollar seen in April was stemmed mid-May as liquidity flowed out of emerging markets back to dollar, although the dollar closed the month 1.5 to 3% weaker against most major currencies.

The markets also witnessed a significant jump in volatility during the month, as indicated by the volatility index VIX which soared from 11.59 to 16.44.

Hedge Fund Performance While directional strategies such as equity long/short and global macro hedge funds bore the brunt of the month's downturn, on the positive side, defensive plays such as arbitrage (+0.8%) and relative value (1.1%) were well rewarded in May. These managers benefited from the volatility in equities, commodities and currencies, while opportunistic plays in the still active M&A space, convertibles and high yield markets have helped event-driven (-0.2%), distressed debt (+0.3%) and arbitrage funds post flat to marginally positive returns. Returns of merger arbitrageurs were still affected by their equity sensitivity, while distressed investments held up remarkably well in the face of a modest widening in corporate credit spreads. Fixed income funds (+0.4%) also had a decent run, as Fed Funds futures traded in a wide range throughout May while market participants scoured economic data and comments by Federal Reserve board members for signals as to the likelihood of another hike in June.

Going Forward As hinted at in our previous review, hedge fund returns have indeed hit a road block in May. The month's sell-off was brought on by rising fears about inflation at a time when most regional markets were fundamentally sound (healthy corporate earnings, positive growth outlooks and the like), as the markets were gripped by uncertainty about the interest rate path that the Fed would choose. Recent US economic data suggests that, while remaining robust, the growth outlook for the next several quarters is slightly lower than previously expected (for instance, payroll numbers in the past couple of months have been disappointing).

Having said that, convertible and equity volatility positions were actively traded during May, and the increase in equity volatility should create opportunities for hedge funds underweighted in such volatility (in addition to creating increased shorting opportunities). Deal flows in the M&A and high yield spaces also remain strong in June. Early June data on convertibles issues suggests that issuers will meet the new-found demand in this area. Market-neutral and opportunistic strategies in general, also seem poised to take advantage of the heightened volatility in the markets.

Please visit http://www.eurekahedge.com/indices for daily-updated numbers on index returns for June.


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