2004 was a trendless and choppy one for hedge fund managers, with a contraction of volatility on both an implied and realised basis, making it difficult for volatility strategies to perform. With the markets trading within fairly narrow bands, it proved a challenge for directional strategies. Relative value managers also found themselves increasingly squeezed by the rising wall of money thrown into the markets by new funds. However, the increase in the number of funds has served to increase liquidity in many markets; and the greater ability to short has helped funds in some previously difficult markets like India and Indonesia. Emerging market debt and distressed strategies were the best performers for the year due to some of the lowest yield spreads in a generation. They were followed to a certain extent, by event-driven strategies.

Regional Overview

The ABN AMRO Eurekahedge Asian Hedge Fund Index posted the largest gain of the year in November at 3.03%, aided by the sharp dollar decline but did not repeat this by the year's close, recording a return of 1.19% in December¹. The ABN AMRO Eurekahedge Asia ex Japan Hedge Fund Index was up 1.56% in December, lifted by an increase of 0.75% in the ABN AMRO Eurekahedge Japan Hedge Fund Index. This increase was brought about by a sharp rallying of Japanese markets by 5.41%² in December.

Asia ex-Japan hedge funds were all in positive territory in December except Greater China strategies which suffered a negative return of 0.33%. The Hang Seng Index was up 1.2% in December — a new high market cap for the year at 14,230 — but the H-Share Index posted a decline of 4.6% in December, on the back of profit taking and corporate governance concerns. In addition, the Shanghai Stock Exchange lost nearly a third of its value since April 2004 at year end. This was due in part to a blanket IPO ban imposed six months earlier as part of China's corporate governance overhaul.

The China Aviation Oil debacle also sent shocks through the market while the arrest of the management of Skyworth hurt market sentiment, sending shares of private enterprises reeling. However, the effect of this decline in private enterprise stocks on the Greater China index was minimal, as there were no large funds which possessed holdings in them.

On the other hand, Taiwan-focused hedge funds saw gains of 4.01% in December, an even greater increase on the November's return of 2.84%. Cross-strait political tensions eased in Taiwan with the opposition, Pan-Blue pro-China party, taking majority seats in the legislature, which helped propel the market up 5.0% in December, ending the year in positive territory.

Indian funds outperformed the rest of the universe with 11.59% returns, driven by strong gains in the Indian stock market, which saw record liquidity inflows into the market as a result of the dollar's decline. Despite the summer political uncertainty, India attracted some US$8.7 billion of net foreign buying — nearly 25% of the flow into emerging markets. Favourable demographics, low cost of capital, improved technology and consumer demand are possible factors leading to long-term wealth creation and asset-reflation for India. Nevertheless, the Indian market has rallied for seven months in a row, with the S&P Nifty up about 10.7% for the year and recording a new high of 2088.45 during December, in contrast to its sharp May decline when it closed at 1483.60. This stock rally stretches both historic and relative valuations and could mean that the market might now be entering a correction phase, possibly all the way up to February when the next federal budget is due. Already there are signs of this correction as latest January figures saw the Nifty close at 1909.00.

Strategy Overview

Strategy-wise, distressed debt funds continued their pace from the preceding five years, returning 6.6% for the three months through December. This result has largely been attributed to the dollar's weakness, which tightened credit spreads for high-yield issues, bolstering gains for distressed debts strategies. Other factors which contributed to these gains are low political risk, GDP growth, high savings rates, current account surpluses and budget surpluses in emerging markets.

Distressed debt was closely followed by event-driven funds which posted healthy returns of 6.39% over the same period. The increase in merger and acquisition activities in Asia during 2004 drove gains for event-driven strategies, which tend to thrive with the increase of public offerings, secondary placements and block trades. The merger for example, of ABC Learning Centres and Child Care Centres Australia, was capitalised on by some event-driven managers.

Increased global corporate activity has benefited both event-driven and distressed debt funds by increasing debt restructuring opportunities, which both strategies capitalised on. However, huge merger and acquisition activity in the last year has given rise to fears that we may be seeing the top of the market for this cycle.

On the other end of the spectrum, funds which had bounced back in November from poor returns in the preceding month, failed to maintain this performance and posted disappointing December results. CTAs lost previous gains on short dollar positions and strong Asian currencies, sinking into the red, down 0.13%. This was due to an arrest in the greenback's decline during the month of December, paving the way for a dollar rally in the first weeks of the new year after a brief low of 1.355 against the euro at the close of 2004. The slide in commodity prices also had much to do with the lacklustre showing of CTAs.

Directional macro and equity long/short strategies, which had cashed in on some developing trend patterns in November to lead the pack with impressive 4.38% and 3.33% returns respectively, also posted comparatively poorer, though still respectable, returns in December. This reflected the impact of the dollar's range-breaking decline in November, which lifted returns in the month to record highs for the year. However, Asian equities were generally positive for the month, despite declining markets in China. This ensured equity long/short strategies remained just behind the distressed debt and event-driven funds with 1.41% December returns. While the December 26 tsunami exacted a tragic human toll on the region and beyond, it had little impact on the markets, and the returns from equity long/short funds were not unduly affected by the natural calamity.

2005 Outlook

Going forward, the threat of a dollar rally heralds dark clouds on the horizon for 2005, particularly for directional strategies. It could threaten the asset reflation trade which Asia/Pacific equities have benefited from since May 2004, as well as clear out many smaller funds that jumped onto the currency trend bandwagon, hoping to capitalise on the range-breaking decline of the dollar in November.

In addition, rising oil prices due to continued violence in Iraq in the run-up to the elections and fears of sharply higher US interest rates, which could bring about a US consumer-led recession, continue to impact investor sentiment in the markets. The threat of a slippage back to deflation for Japan is also one closely watched for by investors in the coming year.

As is currently playing out in the markets, the onset of the recent January dollar rally has dragged down opening figures for the year in many categories of funds. Data revealing strong foreign demand for US assets had assuaged fears that the US will struggle to fund its ballooning trade deficit. This briefly allowed markets to focus on dollar-positive factors such as strong growth and interest outlook for the US, contributing to its rally. On this view, the diversification of reserves by many central banks away from the dollar had already been priced into markets. However, many point to the continuing structural weakness in the US as a sign that the twin deficits will continue to drive down the dollar. The impasse of the greenback at present, lying flat at $1.3040 against the euro reflects the uncertainty surrounding the greenback, amid concerns over issues such as the imminent Iraqi elections, Fed announcement and possible renminbi revaluation.

In spite of this, the general outlook for 2005 remains mildly positive. With leading global indicators in decline since February 2004, there is the possibility that growth in 2005 could be stronger than expected. Any threats to market sentiment are more or less the same as in 2004 — rising US interest rates, high oil prices, a Chinese slowdown and the spectre of terrorism. Managers are expected to position themselves for continued imbalances in the global economy, higher volatilities and decreased visibility in the markets.

¹Based on 90% of the NAV returns
²Nikkei 225 rose from 10899.25 to 11488.76 (30 November 2004 - 30 December 2004)
³Based on data as at Nov-04