Research

Overview

August was a good month for hedge funds on the whole, with most of the Eurekahedge regional indices up by over 1% on average. The month's events were dominated by the yet-to-be fully evaluated effects of Hurricane Katrina, its ripple effects on energy prices (up by about US$10 per barrel from US$61 at the start of the month, breaching the US$70 mark) and global bond yields, as well as on economies with a significant proportion of their budgets going into fuel subsidies, in the Asia-Pacific region. A case in point is Indonesia, whose fuel subsidies account for about 30% of its budget spending.

The key performing regions for the month were Latin America, Japan and Europe, as can be seen from the graph of Eurekahedge hedge fund indices below. The Eurekahedge Japan Hedge Fund Index, for instance, returned 1.72% during the month, while the corresponding Latin American Index was up 1.38%. Funds with flexible global investment mandates have actually mirrored this trend by recovering their losses in Asia and North America through gains in Latin America, Japan and Europe.

Source: Eurekahedge

North America
Europe
Japan
Asia ex-Japan
Latin America

North America

Market Round up

Equity markets in the United States struggled in August, thanks to the persistence of the oil price rises and interest rate fears, despite improving corporate fundamentals. The S&P 500 was down 1.12% and the Nasdaq Composite was down 1.50%. Looking at some of the key sectors, Telecom was weak in August. While wire line fundamentals remained on solid footing, stocks suffered from profit-taking following a strong July. And in Media, newspapers outperformed on speculations that Dow Jones will be up for sale. Online media were weak in anticipation of a slow 3rd quarter and a US$4 billion secondary offering announced by Google.

In contrast to the gasoline price shocks of the 80s, however, the recent increase has been gradual, providing the Fed as well as investors and businesses with more time to evaluate and manage their responses. Despite the overall market pullback, for the first time in quite a while some pockets of the technology space have registered gains. Technology P/E multiples contracted, yet businesses continue to spend. Also businesses' increased willingness, in the IT services space, to hire consultants to undertake discretionary, revenue-driving projects, cannot but be a positive sign for continued interest in this space.

The US treasury market also rallied strongly (10-year yields dropped from 4.28% to 4.02%, while 5-year yields dropped from 4.12% to 3.87%). The rally was especially dramatic during the 2nd half of the month as investors expected higher energy prices to replace higher interest rates. The yield curve continues to flatten with the spread between 2-year and 10-year notes narrowing from 28 to 20 basis points. Credit spreads continued to tighten as general fundamentals improved and earnings were higher than expected.

Going forward the dollar may continue to rally, owing to a fail-safe mixture of loose fiscal and tight monetary policies in the United States.

Hedge Fund Performance

The returns across particular strategies for the month are a good indicator of the toll of the events on US markets. The Eurekahedge North American Hedge Fund Index rose 0.65%. The top performing strategy for August was CTA and managed futures, returning 1.1% for the month, with much help from the continued soaring energy prices.

Event-driven trades have become more numerous over the past two months and present attractive risk-adjusted returns. Many of these situations revolve around M&A activity.

Convertible arbitrage, the top performer in July, however fared less well in August with returns of 0.69%. This has to do with the fact that the US convertible market entered a period of consolidation following strong gains in June and July. Liquidity was thin, trading volumes light, and the market was flat for the most part.

Source: Eurekahedge

Source: Eurekahedge

Europe

Market Round up

Europe had a decent run in August, when improved economic statistics added to a market already buoyed by a weaker euro, stronger cash generation and share buybacks. The European markets were even able to take higher interest rates and oil prices in their stride, as the economy was coursing along on upwardly revised growth forecasts.

The soaring oil prices have made a good bet out of oil service stocks, particularly in Norway. Eastern and Central Europe performed well, very likely to do with opportunities in the event-driven space. Also Russia, particularly sensitive to higher oil prices, proved a good bet for funds. In Russia, the market rallied strongly driven by high oil prices. Market proxy Lukoil, at 35% of the index, led the way with a gain of 17.5%.

The 3-month rally in European equities, however, might be tempered amidst growing concerns of inflation and sapping market confidence in the light of persistently rising oil prices.

Bond yields came under renewed pressure and boosted interest rate sensitive sectors. Emerging market bond yields were strongly correlated to those of US treasuries during the whole month, which in turn, witnessed a strong rally with 10-year yields dropping by more than 20 basis points to 4.02%.

Hedge Fund Performance

August saw good returns of 1.42% across all strategies in the region. Event-driven strategies have come out as the key performers for the month. There are plenty of opportunities in the event-driven space, and not just in the emerging markets in Europe, as IPOs stand a much greater chance of success when the market is going up.

The mergers and acquisition market continued to show strength all round. As many as 14 multi-billion dollar deals were announced during the month. The two biggest deals among these were European, including the one from Suez, Europe's fifth largest utility company, which offered €11.3 billion to gain 100% stake in Belgium's Electrabel. Also, not surprisingly, the oil sector saw three deals announced.

Source: Eurekahedge

Source: Eurekahedge

Japan

Market Round up

The key event in Japan for August was Prime Minister Koizumi's brave stance on the postal reform bill, and his successful result in the snap election. This, and strong fiscal and retail data (domestic housing for July was up 8.3% as compared to 3% growth over the preceding three months), had helped investor sentiment hit a record high, and the equity markets soared. The Topix had its best month this year (+ 5.5%), reaching levels not seen since 2001, ending the month at around 1,280. The breadth of the rally was also impressive, with most of the constituent sub-sectors of the index moving to positive territory. The Nikkei 225 also broke out of trading range and has been trading at 4-year highs (closing at around 12,500 at the end of the month). And not unsurprisingly, there has been an inflow of capital into the Japanese markets.

This strong inflow of funds from foreign investors set the tone for the month. There was concentrated buying in domestic demand and commodities related firms on increased volumes, making this a bullish market. On a net basis, foreign investors poured US$17 billion into Japanese equities in August, as compared to US$10 billion in July.

So why have high oil prices not had that huge an impact on Japanese markets? This has much to do with the quality and quantity of Japan's oil spending. When compared with US spending, not only is oil-spending in Japan (as a % of household consumption) half that of the US, energy consumption/GDP is nearly three times more efficient as well. This may also be a key reason for the de-coupling of Japan to global markets and Asia Pacific in particular.

Hedge Fund Performance

The Eurekahedge Japan Hedge Fund Index returned a robust 1.76% for the month. The key performers were again event-driven funds, returning a stellar 3.11%, followed by long/short equity funds with 1.63%.

Multi-strategy funds fared poorly, in comparison, because of the spikes caused by a lack of liquidity (with many market participants on summer holidays). There were no apparent drivers for trending, and even the sharp spikes were range bound.

Source: Eurekahedge

Source: Eurekahedge

Asia ex-Japan

Market Round up

The region saw a rather mixed month in August. The surge in oil prices fuelled inflationary pressures in the region, as well as concerns over further interest rate hikes. Katrina has added to this by forcing an untimely relaxation of US fiscal policy.

A declining US treasury yield was the primary return driver in the Asian bond market in August as the 10-year benchmark collapsed by 40 basis points to 4%. Asian high grade credit spreads, overshadowed by looming new issuance, widened by 10 basis points, which translated to a loss of about 0.4% in price terms. Asian high-yield bonds were negatively affected (down by 0.5 - 1%) by weak equity markets and the mini-crisis in Indonesia, where credits specifically fell 2 to 3%.

The Asian currency markets finished more or less where they began the month. But the intra-month swings of some were severe. Some of the volatility was attributable to the lack of liquidity due to the summer holidays. The dollar grew stronger as it became popular to speculate about the Fed halting their interest rate hikes to ease the economic slowdown.

Looking at the key events in specific economies of the region, the main one was the instability in Indonesia. The economy was hit by a weakening rupiah as investors worry about the size of the country's overall debt burden. The Jakarta Composite Index was down 11% and the rupiah down 5% during the month. The reason for the heavy toll on the markets is the effect of fuel subsidies - amounting to 85 trillion rupiah in 2004 (3% of GDP; US$9.5 billion) - which took the economy from a budget surplus into a deficit of about 1.2% of GDP. These subsidies have risen to over 140 trillion rupiah (5.3% of GDP; US$ 14.6 billion) in 2005, significantly worsening the fiscal situation. This proves to be a short- to medium-term problem for the nation, as remedial action on this situation could put a damper on economic growth. However, these problems are mostly specific to the economy, and the risk of contagion is low to remote. Also, the economy has a far healthier banking sector since the crisis in 1998.

Among Asian countries that have fuel subsidies, India seems to be the least hit and had nothing more than a slight weakening of the rupee to show for it. The BSE Sensex rose by about 70 basis points for the month. While the month has been more or less flat, positive figures on both the agricultural (good monsoons in the crucial months) and industrial fronts have been very positive, have been responsible for a revision of the growth forecast for FY 2005 from 6% to 6.8%.

Barring a rally in early August, China's equity markets took a break from the upward movements of the past two months. Telecoms, riding on good earnings figures, performed well during the month. Corporate China is also witnessing increasing merger and public issue activity, such as the much-anticipated China Construction Bank IPO.

Korea lost some of the gains it recently made, but it still remains up over 20% for the year. This was amidst favourable economic data (19% year-on-year export growth in August, and 7% growth in industrial output). Concerns over the potential impact of the government's revised real estate policies triggered profit-taking, particularly from foreign investors. And earnings expectations were revised downward after disappointing 2nd quarter results from the IT sector and amplified net-selling by foreign investors increasing market volatility. Pharma stocks, on the other hand, rebounded on strong earnings data and growth prospects.

Hedge Fund Performance

The region returned a rather flat performance for the month, with the Eurekahedge Asia ex Japan Hedge Fund Index rising by 0.1%. Multi-strategy funds have emerged as most profitable (up 0.87%) chiefly due to their well-diversified portfolios, as the region's performance during the month was a mixed bag.

Event-driven funds had a good run and expect to have a continued flow of deals in the near future, mainly due to two reasons - robust capital inflows into private equity funds and the burgeoning of companies from the likes of China and India on the M&A scene. For instance, Chinese National Petroleum Corporation announced the US$4.2 billion purchase of PetroKazakhstan. This is set to give China 12% of Kazakhstan's oil output.

Long/short equity funds bore the brunt of the events and market movements, returning a negative 0.19%. Given the healthy returns in June and July, consolidation was expected but did not happen. Many of the major casualties in the region were in sectors and markets where prices had risen significantly in the previous months. Funds investing in cyclicals, especially in the commodity sector, and tech stocks were hurt.

Source: Eurekahedge

Source: Eurekahedge

Latin America

Market Round up

August closed with strong showings in Latin American bond and equity markets. And in particular there have been positive developments in Brazil and Argentina. The Brazilian central bank has, for the first time in eight months, opted not to raise interest rates. Brazil also enjoyed strong 2nd quarter GDP data.

While Argentina's bonds continued to perform in line with Brazil's, this is below the markets' expectations given Argentina's clearly better political and economic performance. Brazil's corruption scandal continued to take centre stage in the local media, although international investors seem to be indifferent about it, as evidenced by the fact that they are not selling the country's bonds. As long as global liquidity levels remain high, this bullish trend should continue despite persisting structural problems in Brazil's economy, for instance its internal debt.

Venezuela's policies continue to point towards reduced indebtedness, favoured by high oil prices, leading the country's bonds to an all-time high.

Mexico, on the other hand, underperformed over concerns of a US slowdown.

Hedge Fund Performance

The Eurekahedge Latin American Onshore Hedge Fund Index rose a sound 1.81% in August, with the offshore index rising by 1.10%.

Event-driven strategies are, unsurprisingly, the top revenue generators for the month in this region, for both onshore and offshore funds, followed closely by equity-oriented and fixed income strategies. Furthermore, onshore funds have clearly outperformed offshore funds by a big margin. In addition to the usual suspects such as the fact that the region has thriving emerging markets, capital inflows and volatility, there is one interesting reason for this disparity in onshore and offshore fund performance.

Brazil happens to be the most liquid onshore derivatives market among emerging markets and one of the few where onshore liquidity exceeds offshore liquidity. This provides significant opportunities in the form of imbalances between onshore and offshore derivative markets, as well as onshore inter-market relative values, such as foreign exchange volatility arbitrages.

And it is precisely these sharp spikes and the lack of any clear 'trending' that might have led to offshore multi-strategy Latin America investing hedge funds having a bad August. The Eurekahedge Offshore Latin American Hedge Fund Index returned 0.48% for the month.

Source: Eurekahedge

Source: Eurekahedge

Source: Eurekahedge

Source: Eurekahedge

Going forward

The markets can be expected to continue to trade in a tight range as Katrina's net impact is yet to be quantified, and oil prices don't seem to be showing any signs of halting in their rise. There is also the concern over whether the large new issuance in the Asian bond markets can be absorbed into the market, the continuing risk of an inversion of the US yield curve, and of potential Fed rate hikes in the future. However, we feel hedge funds ought to take all this in their stride over the remaining portion of the year, as early reporting funds to the Eurekahedge database have shown very favourable returns so far.

 

For the latest Eurekahedge index values for September, please visit www.eurekahedge.com/indices to access over 150 hedge fund indices.