Tough times continue for hedge funds

New York (CNNMoney.com) -- Hedge fund performance was roughly flat through the third week of July, but a broad market rally in the month's final week could push returns into the black for the first time since April.

Hedge funds on average were down 0.28 percent through July 25, according to Merrill Lynch's hedge fund composite index. Results for the full month are expected on Monday. Those results will include the best weekly returns for the U.S. equity markets in more than a year, as well as this past Monday's weak session.

"It was a month of pretty high volatility," said Larry Smith, chief investment officer Third Wave Global Investors, noting that the equity markets declined in the first half of the month and recovered in the second half.

"If people were long equities, they probably had a rough couple of weeks and a good second couple of weeks," said Smith. "They probably ended up being close to flat. Anybody who was on the short side of things was very quick to cover their shorts" as the markets began to rally again, he added.

Hedge funds are private investment partnerships limited to institutional investors and wealthy individuals. Most hedge fund strategies yielded flat-to-slightly negative returns through the first three weeks of the month.

Equity long/short hedge funds, in which managers take both bullish and bearish positions in stocks, were down slightly for the period. U.S.-focused long/short funds fell about 0.92 percent, while the broader long/short category posted a decline of about half a percent.

Equity market neutral funds, which hold an equal number of long and short positions, were up about 0.34 percent through July 25 and are up 4.59 percent for the year.

Macro funds, which invest in currencies and other instruments in markets around the world, fell into negative territory for the year. The funds were down about 2.17 percent through July 25 and are down 1.58 percent for the year.

Managed futures funds, which trade commodity futures contracts, were down about 1.96 percent through July 25 and are up about 2.06 percent for the year.

Like the equity markets, oil prices experienced a high degree of intra-month volatility, according to Smith. He points out that while the difference in the price of oil from the end of June to the end of July is only about 50 cents, it swung up and down many times throughout the month.

Hedge fund managers were quick to blame escalating tensions in the Middle East for the choppy markets. "It was very choppy waters as people continue to be concerned about the weather in the U.S., demand in China and sociopolitical concerns in the Middle East," said Smith.

But some had no trouble finding tough news closer to home.

"If financial markets were people, they'd be egocentric - they don't care about what happens, they only care about what happens to them," said Jim Melcher, founder and president of Balestra Capital, a New York-based hedge fund. "I don't think the turmoil has affected markets and we didn't react."

But Melcher is bearish on the prospects of the markets beyond the summer months, citing concerns that the economy appears to be slowing. He is also concerned that the residential real estate market may slow down, which he fears could lead to a recession.

The only other strategy besides market neutral to post gains in July was convertible arbitrage. The strategy, in which managers exploit the differences in the prices of convertible bonds and the same company's common stock, continued its steady gains, posting a 0.94 percent gain through July 25.

That brings the total return for convertible arbitrage funds to 5.46 percent for the year, making these funds the top performing strategy for 2006 so far. That's in sharp contrast to their performance a year ago, when big losses in the strategy forced several well-known funds to close.

Other top performing strategies through July are merger arbitrage funds, in which managers seek to profit from the "spread" between the current market price of a company being acquired and the price once a deal has gone through, have gained 5.28 percent for the year through July 25.

Collectively, hedge funds manage about $1.2 trillion in assets, according to Chicago-based hedge fund tracker Hedge Fund Research.