Introduction
Despite some volatility on account of the Lebanon crisis, the hurricane forecasts, the London terror threat, and weak US economic data, global financial markets continued to recover in August on the back of progressively better (or rather less negative) returns seen over the previous three months. The Eurekahedge Hedge Fund Index returned 0.8%1 for the month of August and 6.4% for the year to August. The month saw profitable opportunities in most asset classes, as global inflation fears subsided and the markets began to anticipate the end of the Federal Reserve’s monetary tightening cycle. The Fed’s pause came amid signs of an economic slowdown in the US and forecasts that inflationary pressures will ease gradually. Market movements during the month were shaped by the ceasefire between Israel and Hizbollah (which reduced overall geo-political risk as also the risk premium on oil). Energy prices saw further downward pressure owing to the absence of any disruptions in production despite the active hurricane season in the Gulf of Mexico.
With the Fed taking a pause in its interest rate hikes and benign inflation data, global equity (the MSCI World Index was up 2.3%) and bond markets rallied on forecasts of lower interest rates. The treasury rally also lent strong support to other rating classes, and the high yield market too had a good run. Metals, on the other hand, saw mixed markets; for instance, gold (easing geo-political tensions) and copper (fears over an economic slowdown) declined slightly, while nickel reached record highs on the back of tight inventory levels. And lastly, in the currency markets, benign Japanese GDP and inflation data put downward pressure on future Bank of Japan interest rates, making the Japanese yen the primary funding currency in the carry trade. As a result, the yen reached record lows against most major currencies. US dollar, on the other hand, remained range-bound during the month.
Amidst this backdrop, hedge fund strategies such as relative value, long/short equities, fixed income, distressed debt and multi-strategy, posted healthy gains during the month, as can be seen from the graph below. Event-driven funds benefited from accelerating global M&A activity during the month. Global macro was the only strategy with a negative return (-0.7%), as directional positions in the fixed income markets were hurt by the treasury rally.
Source: Eurekahedge
In terms of regional performance, in a return to pre-May trends, emerging market funds in Asia (+1.7%) and Latin America (+1.4%) posted the best returns for the month, as securities rallied from oversold levels. The MSCI emerging markets index returned over 2% for the month. Among the developed markets, North American hedge funds registered the most gains (+1.2%), while Japanese funds entered positive territory (+0.9%) in August after a four-month spell of negative returns, with the return of foreign buying.
Source: Eurekahedge
Performance by Investment Region – Review & Outlook
North America
Europe
Japan
Asia ex-Japan
Latin America
The Eurekahedge North American Hedge Fund Index returned 1.2% for the month and 7.3% for the year to date. While North American hedge funds had a positive month across all strategies, the event-driven component contributed the bulk of the month’s returns (+1.9%) with M&A activity on the rise, and several special situations spread across various asset classes. For instance, Saxon Capital, an originator and servicer of sub-prime mortgages, was purchased by Morgan Stanley causing the 12% bonds to trade up over 30 points.
Long/short funds too had a good run (+1.3%) gaining from their long bets and losing on their shorts, as the US equity markets rallied (the NASDAQ was up 4.4% and the S&P 500 was up 2.1% for the month) on the back of benign inflation data, a pause in the Fed rate hikes, and a drop in crude prices.
As the Federal Reserve took a pause in its short-term rate hikes and fixed income speculators rebalanced their portfolios, the treasury market rallied (yields on 10-year notes fell 26 basis points to 4.73%, while 5-year yields dropped from 4.9% to 4.69%), and so did the high yield market (best month in over a year, returning 1.6%). This bolstered the returns of fixed income (+1.3%) and distressed debt (+1.2%) players.
Source: Eurekahedge
Going forward, some volatility may be expected in the US markets given the themes of inflation versus recession and the slowing housing market. On the positive side, expectations are leaning towards a heavy new issuance calendar owing to the amount of private equity dollars looking to be invested. The US convertibles market also looks very attractive with generally low valuations and active new issuance, offering numerous opportunities for arbitrage, relative value and special situations managers.
| Strategy | Aug-061 | Jul-06 | ‘06 YTD | 2005 | 2004 |
|---|---|---|---|---|---|
| Arbitrage | 0.72% | 0.74% | 6.84% | 2.65% | 5.28% |
| CTA/Managed Futures | 0.43% | -2.88% | 6.50% | 1.63% | 5.10% |
| Distressed Debt | 1.23% | 0.15% | 9.95% | 11.77% | 23.01% |
| Event Driven | 1.92% | -0.73% | 10.97% | 7.58% | 16.18% |
| Fixed Income | 1.32% | 0.80% | 3.95% | 4.34% | 8.99% |
| Long/Short Equities | 1.34% | -0.34% | 6.81% | 7.68% | 9.15% |
| Macro | 0.36% | 0.76% | 5.69% | 12.43% | 7.23% |
| Multi Strategy | 1.15% | 0.05% | 9.69% | 5.51% | 13.15% |
| Relative Value | 0.91% | -0.14% | 6.89% | 7.07% | 12.27% |
| Eurekahedge North American Hedge Fund Index | 1.20% | -0.34% | 7.30% | 6.80% | 9.83% |
| Source: Eurekahedge |
The European markets were buoyed by positive US treasury data and continued robust corporate earnings data. Compared to price movements in the previous two months, European equities displayed significantly lower volatility during August, with the FTSE Europe index posting a 2.6% gain. Just as in North America, European hedge fund strategies had a good run across the board, boosting the Eurekahedge European Hedge Fund Index to returns of 0.7% for the month and 6.1% for the year to date.
CTA/Managed futures funds posted the best returns for the month among European hedge funds, benefiting from a strong euro, especially against the Japanese yen (given the mixed economic data and downward pressure on Japanese future interest rates), and several opportunities in the commodity markets, led by coffee, crude and silver.
For event-driven funds, the announced merger of Banca Intesa and San Paolo – the second and third largest Italian banks respectively by market capitalisation before the deal – was the most notable event late in the month. But M&A activity during the month was generally on the low, and this was reflected in the relatively lower contribution of event-driven funds to the month’s European index returns.
Source: Eurekahedge
Market movements in emerging Europe too have aided the month’s performance. The MSCI Russia Index returned a solid 4% for the month, and although oil prices have fallen below US$70 per barrel, with the economy continuing to benefit from the overall high export of natural resources. The outlook for the European markets in general, also continues to be positive as there is no major change to the fundamental scenario of reasonable valuations and positive earnings revisions.
| Strategy | Aug-061 | Jul-06 | ‘06 YTD | 2005 | 2004 |
|---|---|---|---|---|---|
| Arbitrage | 0.71% | 0.25% | 3.88% | 0.69% | -1.32% |
| CTA/Managed Futures | 2.41% | 0.86% | 3.94% | 0.04% | -5.16% |
| Distressed Debt | 1.62% | 0.70% | 6.74% | 9.12% | 17.26% |
| Event Driven | 0.84% | -0.23% | 7.59% | 9.81% | 7.97% |
| Fixed Income | 0.57% | 1.22% | 1.08% | 4.74% | 9.31% |
| Long/Short Equities | 0.69% | -0.04% | 6.38% | 14.46% | 10.04% |
| Multi Strategy | 0.78% | 0.26% | 9.28% | 15.21% | 13.12% |
| Relative Value | 0.55% | 0.01% | 5.94% | 6.30% | 2.48% |
| Eurekahedge European Hedge Fund Index | 0.74% | 0.06% | 6.13% | 12.52% | 8.60% |
| Source: Eurekahedge |
Japanese equities were largely in line with US equities, and rallied mid-month; the Topix returned 4% for the month, while the Nikkei was up 4.4%. This was in spite of weak economic data releases, for instance, a CPI decline caused by a base-year change, which in turn triggered a spate of comments that the Bank of Japan had indeed been too early to raise rates. This, coupled with month-end duration extension by insurers and pension funds, led to a rally in Japanese government bonds (JGB), compounded by many players caught and buying back their short positions (JGB yields fell from 1.9% to 1.6% during the month).
These market scenarios helped Japanese long/short managers mark a positive month in August (+1%) but hurt relative value players (-1.6%). As noted elsewhere in this write-up, the downward pressure on future Bank of Japan interest rates made the Japanese yen the primary funding currency in the carry trade. As a result, the yen reached record lows against most major currencies (for instance, 150 against the euro).
Source: Eurekahedge
The near-term outlook for Japan is a little uncertain. Looking back at performance during the past eight months, however, the Japanese markets had quite a few setbacks but the fundamental expansion story is still supported by stronger-than-expected earnings in recent quarters, a return of foreign investors to the markets, and a rise in M&A activity. We continue to expect special situations managers to perform well in these markets.
| Strategy | Aug-061 | Jul-06 | ‘06 YTD | 2005 | 2004 |
|---|---|---|---|---|---|
| Long/Short | 1.00% | -1.37% | -2.99% | 23.09% | 8.02% |
| Multi Strategy | -0.30% | -0.60% | -5.05% | 16.51% | 33.38% |
| Relative Value | -1.57% | -0.75% | 2.70% | 5.54% | 3.51% |
| Eurekahedge Japan Hedge Fund Index2 | 0.85% | -1.50% | -3.07% | 23.48% | 9.31% |
| Source: Eurekahedge |
Asia ex Japan Equity market movements in emerging Asia were again in step with those in the US during August; the MSCI Asia ex Japan Index was up 3% for the month. Looking at movements in some of the key markets in the region, Indonesia remains the top-performing Asian market this year with gains in US dollar terms of 35%.
In India, a strong rebound in global equities and a significant drop in India’s bond yields improved sentiment. The MSCI India Index was up a whopping 9.3% for the month. The rally was also broad-based, with large- and small- cap stocks contributed more or less equally to the growth.
In China, the central bank raised its 1-year benchmark lending rate by 27 basis points to 6.12% for the second time this year, to curb excessive investment. To further mop up excess capital and to relieve pressure over RMB appreciation, the government increased the maximum amount that qualified domestic institutions can invest overseas by 73% to US$8.3 billion. July economic data suggests that the growth trend has slowed to moderate levels.
In Australia, news flow was dominated by company results for the period ended 30 June, as well as increasing speculation on potential M&A activity. As a result, the Australian equities moved higher during the month (+3.3%).
In terms of hedge fund performance, Asia ex Japan was the best performing region for the month at returns of 1.7%, as the region is beginning to see a reversal of the flight-to-quality trades of the past few months. Convertible arbitrageurs posted the best returns among the strategies (+3.5%), as the regional convertibles market looks attractive in terms of implied volatility as well as special situations.
Relative value players benefited from widening credit spreads as the market becomes more cautious about the outlook for global growth.
Source: Eurekahedge
| Strategy | Aug-061 | Jul-06 | ‘06 YTD | 2005 | 2004 |
|---|---|---|---|---|---|
| Convertible Arbitrage | 3.52% | -0.72% | 23.31% | 5.24% | -1.79% |
| Distressed Debt | 0.65% | 1.48% | 6.43% | 9.33% | 19.12% |
| Event Driven | 1.77% | 0.85% | 12.41% | 8.91% | 19.17% |
| Fixed Income | 1.34% | -0.43% | 4.51% | 11.88% | 14.67% |
| Long/Short Equities | 1.70% | -0.14% | 12.56% | 12.62% | 9.63% |
| Multi Strategy | 1.80% | -0.98% | 15.10% | 9.43% | 10.79% |
| Relative Value | 2.54% | -0.85% | 5.08% | 19.90% | -1.34% |
| Eurekahedge Asia ex-Japan Hedge Fund Index | 1.71% | -0.24% | 12.55% | 12.03% | 10.05% |
| Source: Eurekahedge |
In terms of exogenous factors, opinion polls for the Brazilian presidential election show Lula as the favourite, while elections elsewhere in the region throw up little political risk. Economic growth remains strong in Argentina, while economic data emanating from the region is generally positive (Brazil and Mexico announced plans to reduce their external dollar debt, Chile signed a free trade agreement with China thereby diversifying its export base, etc).
Latin American bonds continued their strong performance in August due to the combination of strong fundamentals (Brazil and Peru received rating upgrades) and the positive US treasury environment that emerged in July and was confirmed in August.
Amidst this backdrop, most Latin American hedge fund strategies closed the month in positive territory, with the exception of macro managers that were hit by movements in the treasury markets. The Eurekahedge Latin American Hedge Fund Index returned 1.4% for the month and 11.1% for the year to date.
Source: Eurekahedge
Given the fundamental strength of economies in the region (better governance and macro numbers, resumption of domestic growth, and reduction in external debt), we expect a return of international investors into these emerging markets.
| Strategy | Aug-061 | Jul-06 | ‘06 YTD | 2005 | 2004 |
|---|---|---|---|---|---|
| Event Driven | 2.62% | 2.09% | 14.40% | 28.27% | 26.68% |
| Fixed Income | 1.17% | 1.30% | 9.47% | 19.29% | 15.97% |
| Long/Short Equities | 1.59% | 0.29% | 11.38% | 23.02% | 31.45% |
| Macro | -0.50% | 2.53% | 8.66% | 12.49% | 11.30% |
| Multi Strategy | 1.75% | 1.69% | 11.21% | 19.12% | 19.76% |
| Eurekahedge Latin American Hedge Fund Index | 1.42% | 1.31% | 11.09% | 19.03% | 21.89% |
| Source: Eurekahedge |
Going Forward
While August saw rallies in the global equity and bond markets, the overriding feature of the month’s markets was light volumes. While this is typically the case during the month of August (owing to holiday season in the northern hemisphere), this was particularly so this August. Furthermore, with most regional markets looking towards US economic data for guidance, and uncertainty surrounding inflation and economic growth in the US, any outlook on market movements in the near term would have to factor in this uncertainty. There is also increased risk of margin pressure in 2007 from higher inflation and oil costs. Consumer spending is likely to suffer from higher interest rates and fuel costs.
From the perspective of hedge funds, with increasing IPO and cash-raising activities in Asia, and generally high activity levels in the M&A space, we expect special situations funds and/or those focused on Asia to do well in the near term.
Please visit Indices for daily-updated numbers on index returns for August.
