The composite Eurekahedge Hedge Fund Index fell 1.8%1 for the month of August, shedding some of its gains made earlier during the year and bringing year-to-date returns to a still healthy 7.9%. The decline during the first half of the month was almost across the board (most strategy allocations and all regional allocations finished the month negative), given heightened credit concerns, market volatility and risk aversion. However, central bank intervention mid-month somewhat stemmed the sharp declines earlier in the month, stabilising markets towards month-end.
Most regional hedge fund allocations reflected this in their performance during the month (see graph below). But the month’s worst returns came from Japanese managers (-3%), as yen-funded carry-trade positions were liquidated and the yen rallied against most major currencies.
Global Market Review
As concerns over distress in the credit markets grew and spilled over into other asset classes (with banks and other institutions reporting subprime exposure), market movements during the earlier part of the month were largely a continuation of end-July trends – heightened volatility, lowered risk appetites and flight to safer assets. In the equity markets, this translated into a further decline to historic lows by mid-month for most major indices; at one point during the month, the MSCI World Index was down 5% while Japan’s Topix shed over 13%. In the bond markets, drying up liquidity and the demand for safer government-backed assets sharply widened yield spreads, with the yield on the US 10-year note falling to a 5-month low of 4.48%. In the currency markets, yen-funded carry trade positions were unwound, the yen rose against the US dollar, euro and Australian dollar, and inter-bank lending rates rose.
At this point, the Federal Reserve administered a 50 bps cut (to 5.75%) to the discount rate at which it lends to banks. Other central banks, notably the European Central Bank, too intervened by pumping liquidity into the system. This has had the general effect of calmer markets and rebounding equities, but volatility remained high and risk aversion was still evident from the fact that developed market equity indices managed to recover most of the lost ground by the end of the week, while emerging market indices were still negative at month’s close (the MSCI Emerging Markets Index lost 2.1% for the month of August, while the S&P 500 finished 1.3% higher).
In the commodity markets, the month’s volatility affected metals trading as well. And favourable weather and the absence of any disruptions from hurricane activity, pushed natural gas and crude prices lower.
These broad market trends provide the basis for explaining the performance of various hedge fund strategies during August (refer to graph below). A detailed, region-wise analysis of the underlying factors driving the month's returns is taken up in the following sections of this write-up.
August returns for North American hedge funds were largely flat to negative; the Eurekahedge North American Hedge Fund Index fell 1.1% for the month. Relative value managers were the exception to this trend; they posted the only positive returns for the month (1.3%), capitalising on the short-term opportunities afforded by the atypical and non-fundamentals-driven market volatility. One instance of this strategy that proved profitable during August was trading the put skew in S&P 500 options.
Other strategies that performed relatively better (ie posted the least negative returns) were long/short equities (-0.4%) and fixed income (-0.8%). The former were assisted, to some extent, by the up-turn in equity prices during the later half of August, and profitable short-term plays in the face of, as one manager put it, “leverage-induced liquidation of enormous positions by quantitative equity strategies”, and severe intra-month volatility.
Similarly, fixed income managers benefited from the mid-month bounce back in the high yield market, spurred by the Fed’s 50 bps cut in the discount rate, which has also raised expectations of a cut in the short-term rate in its September meeting.
On the other end of the returns spectrum were North American CTAs, which posted their worst monthly return in over four years (-5.2%), as risk aversion in the credit markets spilled over into the commodity markets, with steep declines in base metals and energy (for instance, copper prices fell 9% during one trading day of the month). Funds were also hurt by long exposure to high-yielding currencies, as carry trade positions were liquidated during the month.
Eurekahedge North American Hedge Fund Index
European hedge funds posted mixed returns across the different strategies, with the Eurekahedge European Hedge Fund Index shedding 1.8% for the month. In the underlying markets, the month witnessed tremendous volatility and panic (due to the US subprime mortgage market meltdown), especially across the debt markets. Towards mid-month, banks, for a short period of time, refused to lend to each other, thereby prompting the intervention of the central banks (to infuse more liquidity into the markets). Also, debt-oriented hedge funds, as well as holders of CDOs were forced into widespread selling in order to meet their liquidity requirements. All these events and activities led to high volatility across equities as well, which ended the month down 0.9% after recovering from an intra-month fall of 7%.
Among strategies, arbitrage and relative value funds registered positive gains of 1% and 0.7% respectively, with some arbitrageurs having successfully exploited the short-term volatility in the markets, and the latter benefiting from effective pair trades (going short on the euro vs long the yen, for instance), among other things. Long/short equity managers on the other hand, returned -2.3%, owing to the level of volatility in equities. However, some managers made gains from short positions (in sectors such as energy, among others), during the month. Multi-strategy managers, too, ended the month down 1.7%, as many stocks and bonds experienced double-digit losses between mid-July and mid-August (while the VIX spiked a little above 35), and the euro declined against most major currencies during the month. Event-driven players were down 2.5% as the M&A activity that was seen till a couple of months back largely dried up, and was replaced by higher borrowing costs dampening the LBO markets, especially for financial buyers.
CTA / Managed Futures
Eurekahedge European Hedge Fund Index
Japanese hedge fund performance can usually be guessed from the performance of equities in the region, as the majority of hedge funds in the region invest in long/short equities. Japanese equities, after exhibiting immense volatility throughout the month (due to the credit crunch caused by the US mortgage market meltdown and the appreciating yen), ended the month of August considerably down. The Nikkei 225, being one of the better-performing indices in the region, ended the month down 3.9%. The broader indices, on the other hand, fell much more during the month – the Topix tumbled 15.3%, after which it recovered strongly, ending the month down 5.7%; the TSE Mothers was down 15.6% towards the month’s close, clearly suggesting that small and mid caps largely underperformed as compared to the large caps.
The yen appreciated sharply during the month, touching 112 against the US dollar (on the back of large scale unwinding of carry trades as, on rising risk aversion, investors liquidated their borrowed-yen-funded speculative assets), thereby having a negative impact on exporters in the region, which in turn affected the entire economy at large (as well as hedge funds in the region).
The Eurekahedge Japan Hedge Fund Index lost 3% of its value in August, owing to hedge fund losses in equities and currencies, among other factors, during the month. Long/short managers finished the month down 2.3% due to poor performance of (and the trendless pattern of volatility in) equities, especially during the first half of the month, and multi-strategy managers ended the month down as well (-1.5%). Event-driven funds posted returns averaging 0.8% for the month, as, among other things, short positions in companies in which activist funds held large stakes proved profitable for some managers.
The Eurekahedge Japan Relative Value Index, on the other hand, fell a steep 10.4% in August. This is partly due to relatively fewer players in this space and negatively skewed returns data, but the sharper declines among index constituents were seen mainly in funds deploying quantitative models. Many such funds sustained abnormal losses during the month, hurt by the indiscriminate closing of long and short positions.
The Eurekahedge Asia ex-Japan Hedge Fund Index ended the month down 1.7%, with mixed returns across individual hedge funds, as well as across regional markets. Most markets in the region tumbled during the first three weeks of the month, and then recovered sharply soon after the Fed announced the discount rate cut towards mid-month. Markets such as China and Hong Kong rallied strongly towards the latter part of the month, mainly on account of domestic factors, while most other regional markets ended negative.
The Shanghai Composite Index, which reached new highs during the month, returned a whopping 16.7% in August (after dipping 4.5% earlier on). The rally was triggered by the announcement that domestic Chinese investors could invest directly into the Hong Kong stock market, which also brought about a rally in the H-shares (7.3%) and a bounce-back in the Hang Seng (which after falling 12% intra-month, ended the month up 3.4%). However, hedge funds in the region didn’t fare as well – The Eurekahedge Greater China Hedge Fund Index ended the month flat, returning 0.01%, as hedge funds (other than a few which posted strong gains for the month) managed offsetting their losses suffered earlier on in the month with profits towards month-end. Chinese long/short managers were down 1%, while multi-strategy managers gained from exploiting short-term volatility during the month, returning a healthy 1.7%.
Markets in Korea and Taiwan ended the month down 3.1% and 3.3% respectively, as, in the former, a notable increase in private sector debt led to the government taking measures to restrict the lending of foreign currency and increase interest rates unexpectedly. In case of the latter, markets dropped on account of profit-taking by foreign investors due to worries on the uncertainty of exposure to the US subprime market. Hedge funds in Korea were down 1.9% while those in Taiwan returned a healthy 3% (as markets, despite ending negative, climbed 12.5% from their month’s low, thereby giving managers good trading opportunities).
Hedge funds invested in Australia/New Zealand and India also ended the month negative (-0.7% and -1.1% respectively); markets in the former were highly volatile, trading in a >500 point range, due to concerns on the US housing market. In addition to that, the Australian dollar saw large declines against the yen as well as the US dollar. In India, markets corrected almost 10%, and ended the month down 1.5% owing to, apart from the US subprime concerns, domestic political instability.
CTA / Managed Futures
Eurekahedge Asia ex Japan Hedge Fund Index
Latin American managers, like most others in August, ended the month negative, with the Eurekahedge Latin American Hedge Fund Index down 0.9%. The MSCI Latin American Equity Index dropped 17.4% intra-month, and recovered to finish the month down 3.2%. During the month, a number of stocks saw intra-day swings in their prices to the extent of 12-18%, most of which recovered their losses by month-end. As borrowing costs in the region shot up drastically, the month saw widespread unwinding of leveraged investments, resulting in a loss of investor confidence.
Arbitrage and fixed income managers, which account for approximately 5% of the hedge funds in the region, returned 1.1% and 0.6% respectively, as arbitrageurs benefited out of the short-term volatility in the markets, while trends in interest rates gave fixed income managers good opportunities during the month. On the other hand, long/short equity managers were down 1.5% (due to the wide swings in equities during the month), while macro managers lost 3% (losing from unfavourable trends and volatility in currencies, among other things) and multi-strategy managers ended the month down 0.7%.
Eurekahedge Latin American Hedge Fund Index
The first few weeks of August witnessed sharp corrections across most financial markets amid concerns over leverage and contagion, triggering a re-pricing of risk, higher borrowing costs, widened credit spreads, and heightened equity and credit volatility. While market participants are still seeking clarity on the impact of the credit tightening on consumer behaviour, the mid-August intervention from major central banks towards easing a liquidity crunch scenario, as also expectations of cuts in the short-term interest rates, has bode well, particularly when business sentiment continues to be resilient.
Indeed, as we write, the FOMC meeting of 18 Sep should be under way, at which markets expect at least a 25 bps rate cut (futures have already priced in a 100% chance of such a rate cut). That said, it remains to be seen whether the Fed rate cut would provide sufficient impetus for a return of risk-taking to the markets.
From a hedge fund perspective, as with any market correction, this will likely provide attractive buying opportunities for fundamentals-driven, long-term positions on the one hand, and profitable short-term trading opportunities on the other.
1Based on 70% of the funds reporting their Aug 2007 returns as at 17 Sep 2007.
2The Eurekahedge Japan Hedge Fund 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.