On the whole, 2007 has been yet another good year for hedge funds, with the composite Eurekahedge Hedge Fund Index1 up a solid 13.6%. This compares favourably with performance during the last three calendar years – 14.4% (2006), 12.2% (2005) and 10.5% (2004). The year’s performance has weathered credit-related woes and the attendant risk aversion, and drying up of liquidity in the underlying markets, which manifested themselves early in the third quarter of 2007. The ensuing down month (August; -1.9%) was one of only two in the last twelve. The other negative month was November (-2%), largely owing to profit-booking after a pro-active Federal Reserve, and a larger-than-expected 50 bps cut in the interest rates mid-September led to a return of optimism into the markets during the following months.
Performance by Strategy
Hedge fund performance during December was underscored by price movements in the energy and agricultural sectors, with CTAs capturing year-end rallies in the crude and soybean markets, ending December up 1.7% for the month and 11.7% on the year. Also capitalising on these directional trends were macro funds, which also ended the month as well as the year on a strong note (1.3% and 12.4% respectively). These two strategies aside, most managers posted modest returns for the month, with gains coming mainly from short positions in the equity and credit markets. The MSCI World index was down 1.4% in December.
To review the performance of various hedge fund strategies in 2007, we compare two measures of the same in the figure below – absolute return and risk-adjusted return (ie Sharpe ratio2). On the basis of the combined measure, style-based performance during the year may be classified into four broad categories in the order of preference of a typical risk-averse investor: high-return/low-risk, low-return/low-risk, high-return/high-risk and low-return/high-risk (assuming a Sharpe ratio of 1 or above as indicative of a ‘low-risk’ strategy and annual returns of 12% or above as indicative of ‘high return’).
While the majority of hedge fund strategies have returned close to or upwards of 12% on the year, an equal number of them appear to have been affected by the mid-year market turmoil caused by the meltdown in the US subprime markets. This has had a negative effect on risk-adjusted returns across the board, with the understandable exception of multi-strategy funds. It is interesting to contrast this with a similar analysis of strategy-wise performance in 2006 – five of the ten strategies studied were squarely in the top-performing category of high-return/low-risk: event driven, distressed debt, arbitrage, relative value and multi-strategy.
Of course, this is by no means a reflection of the quality of the year’s returns per se, as this has to be viewed in the context of conditions in the underlying markets. Significant activity levels (new issuance as well as secondary markets) in the M&A and high-yield spaces favoured opportunistic strategies during the earlier half of the year. On the other hand, arbitrage and relative value players benefited from the market volatility ensuing from the sharp market correction in the third quarter of 2007.
To round up our analysis of the quality of returns among hedge fund strategies, we also compared the dispersion of annual returns across quartiles, as depicted in the figure below. The key observation is that of a significant mean-median differential across most strategies, implying a positively skewed returns distribution and impressive gains among top-quartile managers.
Performance by Regional Mandate
Regional hedge fund performance in December was yet again characterised by healthy gains from emerging market allocations (Asia ex-Japan and Latin America mandates returned 1.4% and 1% respectively), while returns in the developed markets were more modest (0.7% in North America and 0.2% in Europe), if not negative (-1%, Japan). On the year too, there was a clear trend of exceptional returns from emerging market allocations, be they broad or single-country-focused. This was also reflected in the performance of major global equity indices – the MSCI World index rose 7.1% for the year, while the S&P 500 rose 5.5% and the Nikkei fell 11.1%; contrast this with gains in the Shanghai Composite (98%), the Indian Sensex (47%) and the Korean Kospi (32%).
Among other asset classes, oil and gold prices rose over 50% and 30% respectively, while many bond issues and asset-backed indices fell by a similar margin. Combined with an up-tick in market volatility, this has meant that fund returns were widely dispersed based on investment styles and regional mandates, especially during the latter half of the year.
In terms of risk-adjusted returns, performance patterns have, in the main, panned out predictably – emerging markets funds outperformed their developed market peers by quite a margin, as can be seen from the following figure.
Emerging Asia was clearly the best-performing region in 2007 given the high-growth markets of India, China and Korea. Returns in Emerging Asian allocations have bested even those in 2006 (30.4%), with the Eurekahedge Asia ex-Japan Hedge Fund Index recording one of its best years since inception (in 2000) and certainly its best year in the last three. This is also reflected in a comparison of quartile dispersion of returns:
The following sections take up a detailed, region-wise analysis of the underlying factors driving the year’s returns, with some notes on our outlook for the year ahead.
Review – 2007
The Eurekahedge North American Hedge Fund Index was up a modest 0.7% for December, closing the year 2007 up 9.5%. The month’s gains came mainly from long oil and short equity positions, as crude oil prices rallied towards the year-end while equities finished the month lower (the S&P500 returned -0.9%). As with the global strategy indices, the key gainers during the month were CTA (1.8%) and macro (1.9%) managers, while most other strategies were flat to moderately positive.
Performance in 2007 was characterised by strong, bullish markets during the first half, which have somewhat cushioned the credit-crunch-driven weakness in the second half. The end result, as the graph below depicts, has largely been favourable to directional strategies such as global macro (17.3%), managed futures (11.8%) and equity long/short (10.5%). The drying up of liquidity in the M&A and high-yield markets, on the other hand, proved negative for opportunistic strategies such as distressed debt (2.6%) and event driven (5.2%). On average, these strategies weathered three to four negative months in the second half, in contrast with none in the first.
|Eurekahedge North American Hedge Fund Index||0.67%||-1.75%||9.45%||12.31%||7.54%|
Outlook – 2008
Looking forward, we feel that market movements in the latter half of 2007 have created at least a few pockets of opportunities for exceptional hedge fund returns in 2008. For instance, the current environment of reasonable valuations, heightened volatility and a steep yield curve, all make the convertibles market an attractive bet in the coming months. Opportunistic managers may also look forward to a healthy new issuance market driven by cash-strained corporations.
Review – 2007
European markets ended December largely flat, given weak global macro-economic data in the form of downward revisions to growth expectations, rising inflation and risk-averse money markets; the FTSE 100 was up a meagre 0.4%. Together with a round of rate cuts in the UK, this worked against hedge fund positions during the month; the Eurekahedge European Hedge Fund Index finished the month almost flat (0.2%), and returned a modest 4.5% on the year.
For the year as a whole, CTA/managed futures was the best performing strategy, returning an impressive 28.8% on average, on the strength of clearly trending commodity and energy markets. Among other strategies, as with funds allocating to the US, most managers were affected by a weak second half to the year, and only multi-strategy managers (8.2%) were able to effectively translate some of this uncertainty into gains.
Among regional mandates within Europe, Emerging Europe benefited from strong growth themes and fund flows (the MSCI Eastern Europe index up 24%), and hedge fund allocations to the region were up 25.4% on average.
|Eurekahedge European Hedge Fund Index||0.16%||-2.47%||4.49%||12.06%||11.73%|
Outlook – 2008While uncertainty and volatility in the markets is to be expected given the all-round gloomy economic data, consumer confidence could be the decisive factor for positive surprises in the coming months. The global economy will probably continue to expand, albeit at a diminished rate.
As with the US hedge fund space, we believe that the European markets continue to offer niches for significant returns in 2008. For instance, there is a strong case to be made for allocations to Emerging Europe. While the region has lagged other emerging markets in Asia and Latin America as an investment destination, it benefits from strong growth expectations, growing domestic demand, vast infrastructure spending and strengthening currencies. The region could offer non-correlated returns for managers looking to diversify their emerging market allocations.
Review – 2007
The Eurekahedge Japan Hedge Fund Index finished the month of December down 1%, bringing its returns for 2007 to a negative 0.9%. The underlying markets saw a considerable bit of intra-month volatility, with the Topix finishing the month down 3.7%. The main drivers of the negative returns during December were the shipping and financial sectors, among some others; the former saw declines due to profit-taking by investors, while the latter suffered losses due to poor earnings and persistent global credit-related concerns. These, coupled with negative movements across the real estate and utilities sectors (which also accounted for some gains for a few managers holding short positions), brought the returns of long/short managers down to a negative 1.4%. Multi-strategy managers (-1.6%) saw larger declines during the month, partly owing to (apart from equities) trades in bonds and currencies; shorts in the JGBs suffered some losses, while the yen, remaining almost unchanged against the US dollar and the euro, strengthened about 0.9% against the Australian dollar.
December returns of the average event-driven manager, though, were quite impressive amid the market movements highlighted above. The Eurekahedge Japan Event Driven Hedge Fund Index advanced a healthy 1.4% during the month, with one of the index constituents (that aims to profit from corporate special situations, market inefficiencies and index rebalance) widely (positively) skewing the average.
On the whole, 2007 proved to be another difficult year for Japan-focused managers, but it outdid 2006’s performance (-3%). Needless to say that the main drivers of the negative performance of Japanese hedge funds were regional equities; the Topix and the Nikkei declined 12.2% and 11.1% from their December 2006 close. Long/short players, however, making gains from short positions, and offset a large portion of the losses suffered from long exposure, finished the year down a mere (as compared to the equity indices) 0.8%. Multi-strategy managers finished the year flat (0.2%), as profitable trades in currencies (the yen strengthened by 6.5% against the US dollar), among other things, helped in offsetting equity-related losses.
Like in the case of December returns, the 2007 returns of event-driven managers (17.6%) were quite unlike those of other regional strategies. Once again, a similar case of the index average being highly skewed by a particular index constituent that returned in excess of 70% during the year.
|Eurekahedge Japan Hedge Fund Index||-1.03%||-1.68%||-0.87%||-3.03%||23.22%|
Outlook – 2008
Japanese stocks posted the largest losses among the major markets in 2007, amidst a notable decline in housing construction and a state of stagnancy on the wages and consumption front. Domestic markets traded at historically low valuations and most market-players were underweight Japan. However, improving global conditions – of the weakening demand in the US being offset by increasing demand from other markets – could well translate into capacity constraints for Japan in 2008. These in turn could pose attractive investment opportunities in the region for hedge funds and other investors.
Review – 2007
The Eurekahedge Asia ex-Japan Hedge Fund Index finished the month of December up a healthy 1.4%, bringing its 2007 returns to an impressive 32.1%. The main contributors to the month’s returns were India-focused hedge funds, among some others, which registered returns averaging a solid 9.2% for the month.
China-focused funds registered a relatively modest 1.6% this December. This was on the back of some volatility across regional stock markets, coupled with a bit of weakness owing to the prospects of a US slowdown and inflationary pressures on the domestic front. Long/short managers were up 1.1%, despite the majority of Greater China-related stocks closing lower; managers benefited from short positions during the month. Multi-strategy managers recorded better returns, averaging 2.5%, benefiting from, other than shorts in equities, currency trends (as the yuan rose by 1.3% against the US dollar) during the month. Among other movements, the People’s Bank of China, in an attempt to slow the economy, increased the reserve ratio for domestic banks by 1%, and increased both the 1-year deposit rate as well as the 1-year lending rate by 27 and 18 bps respectively.
On the whole, 2007 was an immensely fruitful year for managers allocating to China. The Eurekahedge Greater China Hedge Fund Index advanced by a whopping 55%, on the back of strong gains across regional stock markets, a large number of successful IPOs, healthy FII flows into the region and a strong appreciation of the yuan (approximately 7%) against the US dollar.
Indian hedge funds weren’t too far behind from their Chinese counterparts, with their December returns of 9.2% bringing their 2007 returns up to a sensational 47.9%. December witnessed a 4.8% rise in the BSE Sensex, while smaller caps outperformed large caps for the second consecutive month. Looking at 2007 as a whole, the BSE Sensex returned 47.1%, while India’s other index, the S&P CNX Nifty, rose by nearly 55%. The year saw a good number of successful IPOs, over US$17 billion worth of net inflows from FIIs and an approximate 11% appreciation of the Indian rupee against the US dollar. Against this backdrop, long/short and multi-strategy managers were up by 49 and 48 percentage points respectively, for the year.
Australia/New Zealand-focused hedge funds finished the month of December down 0.4%, bringing their returns for 2007 to a decent 12.3%. The main drivers of the month’s negative performance were the declines of the Australian (-2.6%) and New Zealand (-0.5%) stock markets, and the 0.9% fall in the value of the Australian dollar against the US dollar. Amid these movements, long/short and multi-strategy managers finished the month down 0.6 and 0.1 percentage points respectively. As for the year’s performance, long/short players registered decent returns of 14.2%, outperforming the 13.8% increase in Australia’s ASX All Ordinaries Index, while multi-strategy players returned a bare 4.9% for the year, with a portion of their gains coming from the 11% increase in the Australian dollar, against the US dollar. Australian relative value players finished the month flat (-0.04%), as quant funds failed to exploit the intra-month volatility seen across the region, during the month. However, their returns for 2007 summed up to a better-than-average 14.3%.
Korean managers lost 2.1% in December, while regional markets finished down 0.5% for the month. Weak market sentiment, on the back of weak US economic data and distress among some large international investment banks, was among the main drivers of the markets during the month. However, their returns for the entire year were rather impressive. Despite having faced losses in excess of 6% over the last two months, Korean hedge funds finished the year up, averaging gains of a healthy 27%. A large portion of the year’s gains were realised on the back of positive domestic economic data – such as good domestic sales, healthy exports and strong industrial growth, among other things – during a number of months. The Kospi saw notable appreciation in value, finishing the year up 32.3%, which also went quite some way in shaping the 2007 returns of Korea-focused funds.
|Eurekahedge Asia ex-Japan Hedge Fund Index||1.36%||-3.06%||32.09%||30.44%||13.26%|
Outlook – 2008
Our outlook for some of Emerging Asia’s key economies in 2008 is as follows:
China’s economy, which grew at 11.8% last year, is likely to experience lower economic growth in the year to come. An important factor that is likely to trigger this decline is weak external demand (especially in the US). A recession in the US will largely hamper China’s export demand (although the impact would be some-what cushioned due to the high domestic demand in the country) and higher interest rates would also play a part in the slowing of the country’s economic growth.
One could expect India to sustain strong growth in 2008, given the increasing savings, consumption, investment and outsourcing. Relatively low levels of income and economic development give India the potential to achieve higher growth levels, which would assist it in remaining one of the most rapidly growing economies. Strong domestic demand would work to the benefit of companies and the economy at large. However, the ability and capacity to meet the strong demand would be a key determinant of the country’s performance.
The South Korean economy is estimated to have grown at 4.8% in 2007 (above its target of 4.4%), down from the previous year’s (2006) 5%. However, stepping into 2008, one can expect a decline in exports, on the back of a slowing global economy, and a likely increase in domestic construction investment growth. Hence, being a highly export-dependent economy, one could expect a lower rate of economic growth in 2008, than what has been seen in 2007.
Review – 2007
Latin American hedge funds had a decent run in December, as the Eurekahedge Latin American Hedge Fund Index advanced a decent 1% during the month. These returns were realised amidst quite some volatility in the underlying markets and mixed returns across regional equity markets. MSCI’s indices showed Brazil to be the only positive market in December 2007, registering gains of 2.7%, while Argentina (-4.9%), Chile (-1.7%), Columbia (-3.7%) and Mexico (-1.1%) finished the month in negative territory. Apart from equity movements, favourable economic and political news kept the Latin American markets in good stead in December.
In terms of strategy-wise performance in December, event-driven managers (2.2%) registered the best returns in the region, as some managers stood to gain from positions in the energy, steel, utilities and the consumer sectors. The average long/short manager returned 1.3%, benefiting from investments in commodity-related stocks, among other things. Multi-strategy players were up 0.8%, as equities, commodities and currencies (the Brazilian real and the Columbian peso strengthened 1 and 1.7 percentage points, against the US dollar) posed favourable trading opportunities to profit from. Macro managers (-0.8%) were adversely impacted by the market movements during the month, while fixed income managers finished the month flat (0.04%).
In terms of 2007 performance, Brazil’s IBOVESPA advanced by 43.7% during the year, while Mexico’s IPC General returned 11.7%. This coupled with a notable increase in commodity prices and a 16.7% increase in the Brazilian real against the US dollar, among other things, went some way in assisting Latin American managers achieve their returns of 14.4% for the year. Long/short players (16.9%) were the highest gainers during the year, with multi-strategy (13.6%) and macro (12.6%) players not too far behind.
|Eurekahedge Latin American Hedge Fund Index||0.98%||-1.08%||14.36%||22.23%||17.49%|
Outlook – 2008
Strong growth in Brazil (fuelled by improved credit conditions, rising internal demand and healthy exports) and Argentina (supported by increased domestic demand), offset the slowdown in Mexican activity towards the first half of 2007. However, soon after, Mexico’s close ties with US producers rendered a slowdown in the country inevitable.
Going forward, one could look at a more balanced scenario among the countries (although the prospects would continue to remain brighter for Brazil and Argentina). This is primarily due to marginally decelerating Brazilian activity and Argentine production growth, coupled with a slight rebound in Mexico. Expectations of the auto and machinery sectors, among some others, doing well should provide managers with decent trading opportunities in the region.In Closing
Going into 2008, the markets continue to be characterised by volatility, with counteracting inflationary (booming emerging and emerging emerging economies, profitable corporations, cash-rich oil producers, anticipated rate-cutting from the Fed) and recessionary (fears of a slowing down US economy that may descend into recession, persisting tight credit environment) forces at play. That said, there were plenty of “winners” in 2007 in spite of the mid-year market turmoil.
Our outlook for hedge fund performance in 2008 remains positive, with managers’ selection skills as critical as ever, but also peppered with a healthy dose of caution; for instance, after a broadly bullish 2007 for the commodity markets (crude oil prices rose by over 40% during the year), the coming months may be a good time for CTAs to be managing downside risk. Furthermore, the volatile trading environment ensures a significant opportunity-set of mis-priced assets, and we foresee compelling opportunities in the arbitrage, relative value and distressed debt spaces.
Please visit //www.eurekahedge.com/indices for daily-updated numbers on index returns for December.