Introduction 2005 was a very good year for hedge funds all round, as most Eurekahedge regional indices clocked returns upwards of 10% for the year. The benchmark Eurekahedge Hedge Fund Index1 returned 10% for the year. After a sluggish first quarter and some market turbulence in April and May, most of the global hedge fund universe took off in June and remained buoyant for the rest of the year, particularly so in the emerging markets and Japan. The only exception was the month of October, which witnessed a short-term, end-of-the-year profit-taking. The years performance was also a reflection of the rallies witnessed in the equity markets, which were driven by strong corporate profitability and M&A activity. This explains the healthy profits turned in by long/short (12.9%) and event-driven (8.7%) hedge funds during the year.
The graph below compares the performance of various Eurekahedge regional hedge fund indices against their corresponding MSCI equity indices in 2005. Japan (24.1%) and the emerging markets in Latin America (44.9%) and Asia (16.7%) witnessed spectacular rallies in equities over the year, even outperforming their hedge fund peers on average (see graph below). On the commodities front too, 2005 was a very bullish year for metals, with gold up over 17% and copper and zinc up over 50% each. In the currency markets, ironically, the yen had a difficult year and remained weak despite robust growth in Japan, while the US dollar was buoyed by a number of factors and led to good demand for high-yielding USD instruments despite the case for long-term bearish trends in that currency.
In December, the previous month's bullish trends in European and Asian equities, precious metals and base metals continued, in an otherwise uneventful month. In the bond markets, US bonds rallied on expectations of an end to Fed tightening and European bonds on the expected interest rate hike by the ECB, inverting their respective yield curves. The Fed's uncertainty over rate hikes beyond the one during the month also adversely affected funds involved in currencies, by reversing the steady uptrend of the dollar against Asian currencies including the Yen, and to a lesser extent against the euro. And in the energy markets, in yet another month of warmer-than-expected weather in the US, the bullish expectations early in the month were reversed, leading to some losses. Unsurprisingly enough, equity long/short (+2.9% and +12.9%), multi-strategy (+2.6% and+11.2%) and relative value (+2% and +9.5%) players were the best performers for not just December but also the entire year, across the board, as the graph below demonstrates.
2005 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:
Macro hedge funds allocating to North America turned in healthy returns for 2005 at 12.2%, clearly benefiting from the broad directional trends in equities, metals, and interest rates. The economy continues to be resilient despite the hurricanes and the US job market continues to tighten as the unemployment rate fell to a cycle low of 4.9% in December. High yield and distressed debt players have also fared well at slightly under 10% returns for the year.
CTA/managed futures funds, on the other hand, were hit by mixed trends in the energy and currency markets and were the weaker-performing strategy among North American hedge funds in 2005, returning a mere 1.1% for the year. Convertible arbitrage funds also recorded weak returns for the year at 2.7%. Assets in arbitrage funds, particularly convertible arbitrage, have shrunk considerably after healthy returns in the past, as is evident from a comparison of past return figures from the table below. This is largely perceived as a cyclical phenomenon and funds allocating to this strategy should return to positive territory in the coming year.
|EurekaHedge North American Hedge Fund Index||1.36%||1.61%||6.81%||9.88%||21.77%|
Multi-strategy hedge funds were the top performers in Europe for 2005, posting solid gains of 14.2%. They were assisted by healthy rallies in European equities, particularly in the Russian and Eastern European bourses, over the year. This in turn was driven by strong balance sheets, stable economic growth, cash-rich private equity funds and an ample influx of liquidity from the credit markets. These positive factors were, of course, also favourable to strategy-specific hedge funds such as long/short equities (+14.2%) and event–driven funds (+9.5%). In a year that saw the announcement as well as the closing of several multi-billion dollar deals, hedge funds allocating to the event–driven space have had a decent run. For instance, the Belgian telecom services company, Telindus, performed rather well as France telecom and Belgacom fought over acquiring it. The investible universe for merger arbitrage has certainly expanded in 2005. Key performing sectors in equities also included telecom stocks (eg France telecom, Telefonica, Telecom Italia) and petroleum and automobile stocks.
CTA/managed futures funds, on the other hand, were the worst performers for the year, with returns of under 1% for the year. Gains made from allocations in stock indices and certain commodities such as metals, just about compensated for losses in the currency, energy and interest rate allocations amidst choppy markets.
|Eurekahedge European Hedge Fund Index||2.13%||1.73%||12.20%||8.76%||10.49%|
Japan Japan's return to economic growth is arguably the most important development in 2005 within the regional markets. The new climate in Japan favours enhancing shareholder value over a stability through cross shareholdings. This has created a very conducive environment for equity investments and given a fillip to M&A activity. And these were indeed the two best performing strategies in 2005 – event–driven and long/short equities. The former posted spectacular returns at close to 46% for the year, in a year that saw a rise in stock-splits and completed merger deals such as those in Tokyo-Mitsubishi and CITIZEN.
Funds allocating to equities have also posted solid gains at 23% for the year, aided by the strong spike in equities as the benchmark indices, Nikkei and Topix, reached multi-year highs.
|Eurekahedge Japan Hedge Fund Index3||5.82%||2.60%||23.55%||9.22%||18.37%|
The broad-based rallies in equities seen in the region have buoyed up relative value (20%) and long/short funds (12.1%), as can be seen from the graph below. For instance, in December alone, the Nikkei was up 9.97% in dollars, India gained 9.07%, Korea 8.79%, Indonesia 8.05%, Taiwan 7.79% and Thailand 7.43%. Singapore, Malaysia, Australia and the Philippines gained more modestly. The Chinese markets were the worst performing in the region in 2005 (for instance, the Shanghai B Share Index fell by 18%), although this is slated to change in 2006 owing to the underlying strength of the Chinese economy as well as government-driven reforms.
In Korea, over the year, equity markets have seen very sharp liquidity-driven rises in 2005, with the KOSPI shooting up 54% year-on-year. The surge in liquidity in the markets, unlike the inflows into other economies in the region, was domestic-investor-driven - mainly pension funds and local investment trusts reallocating capital from bonds to equities - underscoring the strength of the local savings industry. As a result of the sustained productivity boom, Korean exports grew a healthy 12.2% during the year.
In India, the markets rose 37% for the year, amidst positive economic data, attractive valuations and continuing infusion of liquidity.
In Australia, the modest gains over the year does not reflect the strong performance of the equity markets during the last two months, on the strength of rising commodity prices and positive outlook statements.
As in the US, in Asia too, convertible securities look poised for a boost in 2006 after shrunken assets and sluggish markets in the past. This is also hinted by the stellar returns of over 3% posted by these funds in December, as investors were visibly lured by the low valuations.
|Eurekahedge Asia ex-Japan Hedge Fund Index||3.19%||3.13%||11.74%||9.97%||32.33%|
Brazilian onshore hedge funds outperformed their offshore peers in 2005, returning 20% to the latter's 14.5%. Brazilian funds have ridden on favourable economic news such as decreasing external debt, maintenance of a robust primary surplus and swelling foreign exchange reserves (reaching the US$50 billion mark in December). This has also led to a reduction in its country risk further assisting capital inflows.
Furthermore, both Brazil and Argentina have announced that they will repay their IMF debt two years early, signifying a shift in preference towards market-based access to funds.
The positive environment in Latin America, especially in the equity markets, has benefited long/short and event-driven funds, and they were the best performing strategies both on- and offshore, as demonstrated by the graphs below.
|Eurekahedge Latin American Offshore Hedge Fund Index||1.81%||2.35%||20.00%||19.66%||54.11%|
|Eurekahedge Latin American Offshore Hedge Fund Index||0.35%||2.61%||14.53%||21.12%||36.70%|
Outlook for 2006
The outlook for hedge fund performance looks very bright in 2006. On the strategies front, prospects for arbitrage funds look promising, as secondary market trading in convertibles was higher in the fourth quarter. Given the bearish nature of these markets over the past few years, investors are bound to find the valuations very attractive in 2006. Furthermore, a buoyant world economy and strong corporate profitability and M&A activity, should support, if not boost, global equities in the near term, spelling good news for equity long/short and special situations players.
Investment region wise, the anticipated end of the Fed tightening spells positive news for Asian equities in general. More specifically, in China, new rules allowing foreigners to invest in the larger A Share market are likely to lead to better market performance, given a strong Chinese economy and a government pro-active about stimulating domestic demand. Also, markets in Hong Kong, although up only 4.8% in 2005, are the most sensitive in the region to US interest rates and will be an early beneficiary of the expected end of Fed tightening. 2006 also looks bright for China's State Owned Enterprises to get listed in Hong Kong. After the successful debut of China Construction Bank, China's remaining three state-owned commercial banks are gearing up for listing in 2006, to operate efficiently in a market-oriented environment.
The positive fundamental factors in play in the Korean markets (as discussed elsewhere in this write-up) spell a good year ahead for the Korean economy. For instance, the robust corporate sector could well support employment and higher wage earnings in 2006, and improved credit line conditions in the banking sector mean further liquidity pumped into the economy in terms of consumer and corporate credit. However, there are concerns over the rapid appreciation in the Korean Won, which may temporarily aggravate market sentiments and increase volatility. But on the whole, the 2006 outlook for Asia is bright, and if Korea's strong intra-regional export growth in 2005 is anything to go by, the uptrend might yet be sustained.
The outlook for Australia is solid as well, given a combination of reasonable profit growth and attractive dividend payouts, and a shift in investor focus away from real estate. In India, on the other hand, although the solid gains made in 2005 expose it to the risk of profit-taking, the fundamentals for a long-term positive investment environment are very much in place.
In the Latin American markets, in Brazil, despite the possibility of occasional corrective moves, abundant global liquidity and rising disposable income resulting from declining domestic interest rates should be supportive of new gains in the year that just began. Sectors that should benefit the most include Consumer Goods and other Cyclicals. Also, in December, both Brazil and Argentina announced early repayment (by two years) of their IMF loans. This would mean greater market access for funds for these economies, going forward. However, there are some risks associated with the fact that 2006 is election year in the region.
Moving on to the risks, global risk aversion remains a key risk. It would also be prudent to examine some of the potential negative surprises such as decelerating profit growth, rise in inflation, reduced consumer spending or a collapse in property prices in the US or Asia. There is also the risk of a slowdown in US consumer spending, an important driver of global growth. Coupled with a weakening US dollar and an end to the Fed tightening cycle, this might channel liquidity away from economies sensitive to global growth such as South Korea, and towards others in the region that are more sensitive to movements in the US markets (such as Hong Kong).
The prospective changes in central banks' policies in 2006 could also significantly alter both the amount and composition of global excess liquidity. For instance, the ECB raised interest rates in December for the first time in more than five years. The implications of this move become apparent when one realizes that the ECB was the world's largest supplier of excess liquidity in 2005, and is finally starting to tighten liquidity. Any of these would cause a decline in global trade, adversely affecting hedge fund performance in the coming year. On the positive side, the bank of Japan could take on the role of providing such excess liquidity in 2006, given that its zero-interest-rate-policy would be in place until 2007 and Japanese economy is on an expansionary cycle.
To summarize, the progress in industrialization in china and the restructuring-fuelled boom in Japan and Europe could be sustained over the next year. On the whole, 2006 presents a benign growth picture.
1 Based on 88.73% of the NAVs of 2,262 constituent funds for December 2005 as at 28 January 2006
2 Based on 93.36% of the NAV data for November received to date (2 January 2006)
3 The 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.