Introduction

After the robust returns seen in the past few months, markets and investors paused for a breather in February, and this was reflected in the performance of the Eurekahedge Hedge Fund Index¹ (up 0.2%). The key drivers of hedge fund returns during the month were bullish emerging markets, market neutral strategies and special situations.

Most funds allocating to emerging markets posted gains upwards of 1% on the back of continuing high demand from investors. European hedge funds did well (+1.4%) as equities were up 2% for the month, driven by consolidation in the corporate sector. Eastern European equities were a key contributor to the month's rise. The performance of Asian funds on average (1.3%) was slightly dampened by weakening sentiment in key markets in Korea (down 2.7%), Australia (down 2%) and the like. North American equities, on the other hand, had no clear direction (the NASDAQ Composite was down 1.1% while the Dow Jones Industrial Average was up 1.2%), and January's Livedoor scandal continued to plague Japanese equities (down 3%). The graph below captures the month's pattern of regional hedge fund performance discussed above:

On the strategy front, multi-strategy funds continue to generate solid returns. Corporate activity is at healthy levels globally, benefiting event-driven and distressed debt funds (the first two months of the year have already witnessed the announcement of over 1,500 deals collectively worth close to US$300 billion), while stable credit markets and rising interest rates have proved favourable to fixed income managers. However, concerns over rising short-term rates and the flattening yield curve negatively affected other funds. The commodity markets – especially energies and metals – also experienced significant corrections, with the CRB index plunging 8% in the first two weeks of the month before bouncing back. There were also fears of a slowdown in the US housing market, given the rising rates. These factors are reflected in the following comparison chart of the performance of various hedge fund strategies for the month:

Eurekahedge Performance Indices (Srategies)

February 2006 Hedge Fund Performance – by Investment Region
This section takes a closer look at trends in hedge fund performance in each of the following key investment regions:

North America
Europe
Japan
Asia ex-Japan
Latin America

North America

February saw North American equity investors shuffling their sector allocations, with oil-related stocks taking a dip while the stocks in the tech and healthcare segments were on the rise.

Treasury markets also witnessed a dip as 5- and 10-year yields rose 4 and 3 basis points respectively. The yield curve continues to flatten, with contracting spreads between 3-month bills and 5- and 10-year notes (yields at 4.59%, 4.6% and 4.55% respectively). Furthermore, the new Fed Chairman, Ben Bernanke, in his inaugural address mid-February, commented that the Fed tightening cycle would likely continue.

With the markets expecting further rises in the interest rates to restrain inflation in the US, commodity prices fell with aluminium leading copper and other metals lower mid-February (the US being one of the biggest consumers of aluminium and copper). The plunge in energy prices (US natural gas fell 27% while crude oil lost 9.5%) was due to continuing warmer-than-expected weather coupled with high inventories.

No surprise then, that CTA/managed futures funds were the worst-hit during the month, dipping almost 1%. Macro hedge funds, who had initiated the sell-off in commodities, also had to give back some of their profits during the month.

On the positive side of the return scale were distressed debt and event-driven funds, both of which returned upwards of 1% for the month. Deal flow in the US new issues market was healthy, with the month witnessing two large, well-traded, multi-billion dollar deals – 1) Amgen Inc raised approximately US$5 billion through the issuance of two convertible notes to fund its share buyback programme and 2) UBS underwrote a synthetic derivative exchangeable into Time Warner stock.

Arbitrage funds also performed well during the month, largely assisted by the positive turn that the under-valued convertibles market is taking.

Outlook

The months ahead for North American hedge funds look positive as the coming month shows signs of more opportunities in the new issues market. Valuations in the convertibles space also continue to be attractive.

Europe

European equity markets rose 2% over the month, notwithstanding increased volatility, on the back of stronger-than-expected 2005 earnings data and the accompanying positive outlook for the year ahead. Eastern European equities did especially well, with, for instance, the MSCI Russia Equity Index returning a whopping 7.1% for the month. European economic data too remained very firm, with the key German economic indicator, the IFO index, rising 6.5% and reaching a new 10-year high in February.

The treasury markets had a quiet month in February. Volatility levels came down sharply and yield curves flattened as the market expects a rise in interest rates in the near term, although the ECB has left interest rates on hold.

M&A activity continued, especially in the utility sector, as Gas Natural bid for a hostile takeover of Spanish utility giant, Endesa, with a competing bid coming from the German utility company, E.ON. The event holds several opportunities for merger arbitrageurs as the Spanish government tries to fend off the foreign bidder, an act that is being seen as a violation of EU rules governing fair competition. In France too, a similar government-aided merger was announced between Suez and Gaz de France, to fend off a hostile bid from Italy's Enel SpA. This deal too has come under the purview of EU regulators. Meanwhile, Mittal Steel's takeover bid for Arcelor is still on course.

Multi-strategy funds registered the best gains for the month at over 3%, clearly benefiting from an investment environment conducive to a diversity of opportunities. Long/short and arbitrage funds were also among the better-performing strategies for the month.

On the flip side, fixed income players were the worst performers for the month (-0.13%), caught off-guard as they were by the Danish central bank's independent rate hike and the resulting widening of spreads.

Outlook

Things are looking up in other European markets too, and not just in the emerging market space. Europe's largest economy, Germany, is expected to witness an upturn, given the sharp rise in its key economic indicators, notable the afore-mentioned IFO index.

Japan

February was a turbulent month for Japanese equities, with the TOPIX experiencing steep declines during the month (the intra-month high/low differential was 9 percentage points at its widest). Both the Topix and Nikkei indices shed more than 2.5% over the month. On the bright side, this had largely to do with continued investor jitteriness following the previous month's Livedoor stock manipulation crisis, and not so much with any fundamental problems in Japan's economic health. Consumer confidence continues to be high (as suggested by the strong numbers for consumer credit, retail spending and housing starts), and the GDP grew by 5.5% in 2005.

However, there was another, more fundamental reason for the month's correction – during the month, the Bank of Japan signalled (as confirmed in March) to the market a possible end to the zero interest rate policy as the economy is now up on its feet.

Given the afore-discussed, albeit short-term, market correction, Japanese hedge funds had the worst month in almost a year, dipping 2.6% for the month. Almost all strategies performed negatively during the month, with the exception of market-neutral relative value funds.

Outlook

As mentioned earlier, what the month saw was merely a short-term correction, to be expected in any bull run as investors pause for profit-taking. The fundamental strength of the economy remains intact, with rising asset prices and recovering consumer and investor confidence. Furthermore, the correction would enhance the attractiveness of market valuations.

Asia ex-Japan

Equity markets in the rest of Asia were widely divergent with respect to performance during the month. While Korean and Australian equities shed over 2%, other markets in India and Hong Kong registered stellar gains (upwards of 3.5%). This is a sign of the kind of concerns looming over the region's equity investment horizon – rising interest rates and global inflation and overstretched US consumer demand.

The credit markets also performed well, despite rising geo-political risk in Thailand and the Philippines, and interest rates are heading up for the right reasons ie domestic economies are doing well. The markets also benefited from speculation surrounding another round of appreciation of the Chinese yuan.

Looking at market movements by region, Hong Kong's China stocks were the best performers in the region, surging ahead nearly 4% for the month. Mainland Chinese stocks, on the other hand, seem to have slowed down by way of correction, as compared to the sharp rises seen in January. Continuing regulatory and structural reform and a buoyant economy also bode well for further investor interest and M&A activity.

India too saw rallying equity markets in February (+2.5%). The Union Budget towards the end of the month did not spring any surprises. Deal flow in the new issues market is also robust – estimated at over US$25 billion. Pharmaceuticals and cement are attractive sectors in terms of M&A opportunities.

In Korea, on the other hand, the equity benchmark KOSPI fell 2.2% over the month. Despite favourable macro variables in play (domestic demand continues to firm up, GDP expected to grow at 5% in 2006), investors' risk appetites have been lowered amidst concerns over the strengthening Korean won and its effect on earnings in export-related names.

As seen above, M&A activity in the region is on the rise. The month saw several new deals announced, including American billionaire Carl Icahn's bid for the South Korean tobacco maker KT&G Corp, the Newbridge/Texas Pacific Group's bid for Pacific Century Group, and in Taiwan, Chinatrust Financial's (credit card issuer) purchase of a stake in Mega Financial Holding Co, to name a few. Consequently, event-driven funds performed rather well during the month, returning 3.2%.

Activity in the convertibles space too is on the rise, as discussed elsewhere in this article. These funds were the next best performers, returning 1.4% for the month.

Latin America

February turned out to be yet another positive month for Latin American markets. As in previous months, emerging markets continued to benefit from the large inflows of liquidity.

For instance, in the debt markets, the Brazilian government's announcement to buy back portions of its external debt to the tune of US$20 billion using its forex reserves, sent bond prices rallying. Brazil's strong forex reserves position was attributable to a strengthening of the Brazilian real as well as positive trade account flows.

Other Latin American economies such as Mexico and Venezuela followed suit with announcements of similar debt buyback plans. Low volatility in the US treasury markets further assisted the rally, and Argentinian bond prices too picked up steam.

Latin American equities, on the other hand, were nowhere near the rallies seen in the previous month. The MSCI Latam Index was up just 0.8% for the month.

The bulk of the month's returns then, as reflected in the graph below, were to be made in local markets, dollar-denominated corporate bonds and, to a lesser extent, equities. The market for new issues too saw a lot of activity, with Brazilian builders Rossi, Gafsia & Company tapping the market. There was also an IPO by the Brazilian state-owned water utility company, Copasa. As a result, the best returns were to be seen in event-driven, multi-strategy, fixed income and long/short funds in that order. Offshore long/short funds had a better run at the equity markets as the month saw a weakening of the US dollar against the Brazilian real.

Outlook

The main cause for concern is the exuberance of investors, betrayed by the unprecedented level of liquidity in the region. The markets are beginning to focus on the possibility of a correction in this respect, especially as a tighter monetary policy in most developed economies would put a squeeze on global liquidity. Risk appetites are also expected to be lowered later in the year, as large economies like Brazil and Mexico go to the polls. On the bright side, the rally in the region's fixed income markets also had the effect of making equity valuations very attractive, as the prices did not reflect the strong drop in the discount rates.

In Closing

To recapitulate, hedge funds had a flat to rough month in the North American, Japanese and some Asian markets, while the rest of the emerging markets continue to attract global liquidity and to generate robust returns. The month's events are broadly seen as a bout of profit-taking by investors, and the correction, just as in October last year, is of a short-term nature. This is corroborated by the fundamental strength of many of the markets that ended the month lower, such as Japan and Korea. The outlook for emerging markets as an asset class continues to be positive, with strong secular growth expected in China and India, and improved expectations in Japan and Europe, and commodity-backed economies (such as in Russia and Latin America) could become a "safe-haven" asset class in 2006.

On the risks front, the spectre of rising interest rates is looming large on the investment horizon for global equities, as most major central banks are slated to re-start or continue on their monetary tightening cycles. However, strong corporate earnings as well as a rise in M&A activity globally, should continue to present interesting opportunities for equity-focused strategies.

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

Footnotes

¹Based on 99.86% of the NAV for Jan-2006 as at 01-March-2006
²The All Strategies 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.