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Hedge funds fall for first time in seven months

Date: Wednesday, November 11, 2009
Author: Hennessee Group

The Hennessee Hedge Fund Index declined 0.50 per cent in October, bringing its year-to-date performance to +20.12 per cent, according to the Hennessee Group.

The S&P 500 fell 1.98 per cent (+14.72 per cent YTD), the Dow Jones Industrial Average was unchanged (+10.67 per cent YTD), and the Nasdaq Composite Index declined 3.64 per cent (+29.68 per cent YTD). The Barclays Aggregate Bond Index advanced 0.49 per cent (+6.24 per cent YTD). 

“After seven months of positive gains in the equity markets, the liquidity driven rally showed signs of weakness,” says Charles Gradante, co-founder of Hennessee Group. “So far, this rally has been driven by multiple expansion. We need to see earnings growth for the rally to be sustainable. This should be a good environment for hedge funds, as greater dispersion and volatility among industries and companies will benefit fundamental security selection in both long and short portfolios.”

The Hennessee Long/Short Equity Index fell 1.39 per cent in October (+17.07 per cent YTD). The equity markets retreated in October despite better than expected earnings reports and encouraging economic data.

Small cap stocks were particularly weak in October, hurting hedge funds, as the Russell 2000 Index fell 6.9 per cent. Biotech stocks were another area of weakness with the Nasdaq Biotechnology Index down 9.9 per cent in October led down by Amylin (-19.4 per cent) and Biogen (-16.6 per cent). 

Despite their cautious stance, hedge funds struggled to generate positive results during the month as gains on their short positions were unable to offset losses in their long books. Going forward, hedge funds will remain defensive as valuations remain stretched and numerous headwinds exist that could slow the pace of the global economic recovery.

“The commercial mortgage-backed securities space remains an area of interest and frustration for managers. There is certainly a disconnect between fundamentals and prices,” says Gradante. “Fundamentals continue to deteriorate as delinquencies rise, vacancies increase, and rents decline.  However, risky tranches of CMBS have rallied along with other risk assets.  There have been some positives for the sector, including improved investor sentiment and government programmes aimed at helping the sector (TALF and PPIP). Managers are finding many short and long term opportunities on both the long and short side.”

The Hennessee Arbitrage/Event Driven Index gained 0.81 per cent in October (+24.45 per cent YTD).  Arbitrage and event driven funds outperformed long/short equity funds as credit and merger spreads continued to tighten. The spread on the Merrill Lynch High Yield Index tightened further from 793 basis points to 760 basis points during the month, after hitting a low of 735 basis points early last week.

Managers are bearish on risky high yield debt, where prices have rallied significantly, but fundamentals remain poor.  The Hennessee Distressed Index advanced 1.43 per cent in October (+30.13 per cent YTD).  Distressed funds have benefited this year due to their directional bias.  Default rates have started to ease and several sell side research firms are forecasting lower default rates in 2010. However, managers report that there remains over USD1trn in high yield maturities over the next five years, and remain optimistic on classic distressed investing. 

The Hennessee Convertible Arbitrage Index advanced 1.00 per cent (+40.74 per cent YTD). Spreads made a positive contribution to convertible portfolios, while volatility, market cheapening and interest rates were negatives. While broad cheapness is gone, managers remain bullish on the outlook for convertible arbitrage as there is less competition, and long only and cross over buyers are providing stability.

The Hennessee Merger Arbitrage Index advanced 0.30 per cent in October (+7.11 per cent YTD). Managers continue to be very active in large strategic deals, especially pharmaceutical deals. Hedge funds and proprietary trading desks have increased exposure causing spreads to compress. Most managers expect M&A activity to pick up and will look to increase their portfolio allocations to the strategies, especially as other strategies become less attractive.

The Hennessee Global/Macro Index was essentially flat in October, down 0.12 per cent (+21.15 per cent YTD). Global equities declined as the MSCI EAFE Index declined 1.29 per cent (+23.87 per cent YTD), with developed markets driving negative performance.   
The Hennessee International Index declined 0.91 per cent (+17.73 per cent YTD). Managers made money in emerging markets, particularly China, which released positive economic data, and Brazil, which saw large foreign inflows. 

The Hennessee Macro Index fell 1.20 per cent in October (+8.66 per cent YTD). Managers lost money on the short dollar trade, which is pretty widely held. While the dollar rallied in October versus most major currencies, most agree that the long term trend for the dollar is going to be negative. Managers also suffered losses long the equities of developed markets, which experienced a correction.

Managers made money in gold, which is another common theme as a hedge against the dollar and inflation. Managers also made money in fixed income as the yield curve steepened. The two-year treasury yield eased from 0.96 per cent to 0.90 per cent, while the ten-year treasury yield edged higher from 3.31 per cent to 3.41 per cent and the 30-year treasury yield fell from 4.03 per cent to 4.23 per cent.

“Macro managers are quite focused on the fixed income markets,” says Gradante. “At some point, we are going to see central banks reverse their quantitative easing efforts. The consensus is still short long-term US treasuries as yields are too low to attract foreign buying.”