JANUARY 2010

 

The broad hedge fund indices of the HFRI Fund Weighted Composite and HFRI Fund of Funds Composite both lost 0.7% in the January.  While unable to provide positive returns during the month, hedge funds effectively mitigated downside equity risk, participating in less than 20% of the S&P 500’s negative performance of -3.6%.

 

The “January effect” held true for equity markets the first half of the month, but markets quickly retreated after a press conference held by President Obama on January 21.  During the press conference, the President highlighted amendments to the financial services reform package, dubbed the Volker Rule.  The new proposal would limit the size of deposit-taking banks and eliminate lucrative activities, including proprietary trading and owning private equity and hedge funds.  As expected, markets reacted negatively to the news, erasing the first few weeks’ gains with share prices of investment banks suffering the worst of the sell off.  While the announcement was certainly a short-term headwind, hedge funds could be longer-term beneficiaries should the reforms come to fruition.

 

The importance of investment banks’ proprietary trading desks diminished significantly with required deleveraging in 2008 and 2009. Leverage decreased from in excess of 30 times to the low teens in order to meet the requirements of bank holding companies.  Plans to bolster those trading desks as markets normalized will likely be on hold until banks gain clarification surrounding possible regulations.  Decreased competition would be positive for hedge funds operating in strategies whose trades can often become crowded.  Secondly, hedge funds should be the recipients of a boon of investment talent, as banks may be forced to divest of these assets, leading to an exodus of talent leaving Wall Street for opportunities within hedge fund organizations.

 

 

Directional

 

The sharp decline of the equity markets in the latter half of the month was a headwind for long/short equity managers, as the HFRI Equity Hedge (Total) Index fell 0.9%.  The selloff was broad, with little dispersion as growth and value, and small and large capitalization stocks all realized negative returns.  Most hedged equity managers steadily increased their net long exposures during 2009 and were again within historical averages.

 

Recent volume in the equity markets continued to be weak, highlighting the importance of managers to be nimble and maintain flexibility to adjust exposures in times of opportunity and risk.  Profits in long/short equity during January were due primarily to idiosyncratic positions and positive returns in managers’ short books.  Short-biased managers, after realizing difficult performance of -24.0% in 2009, were some of the stronger performers during the month.  The HFRI Equity Hedge Short-Bias Index gained 1.7% in January.

 

Saber rattling by the Securities and Exchange Commission surrounding possible shorting regulation and disclosure continued to be in the forefront of conversations of hedged equity managers.  A recent study by the Managed Funds Association (MFA) illustrated that public short-sale disclosures in the United Kingdom have produced unintended consequences, such as significantly increasing bid-ask spreads by approximately 45%, making trading costs for investors much more expensive.  Many managers will express that they do not have reservations about privately reporting short positions to a central regulated body, such as the SEC, but fear public disclosure would be a detriment to the research process.

 

Managers specializing in emerging markets posted negative returns in January, as emerging markets generally underperformed their developed counterparts.  The HFRI Emerging Markets (Total) Index was down 1.2%.  During the month, China raised its bank reserve requirement by 50 basis points and India increased its reserve ratio by 75 basis points.  Within emerging markets, the HFRI Emerging Markets: Asia ex-Japan Index was down 1.9% and Russia/Eastern Europe fell 0.8%.  Latin America was the weakest component in the broad index, losing 3.7%.

 

Global trading managers suffered poor performance in January, as the HFRI Macro (Total) Index, down 2.2%, was the worst performing major sub-strategy.  The majority of managers posted positive performance in the first few weeks of the month, but quickly fell, as the U.S. Dollar rallied against several currencies and commodities suffered a broad sell off.  Gold fell 1.2% to $1,083 per ounce and the price of oil declined 8.2% to $73 per barrel.  The energy dominated GSCI Commodity Index was off 7.3% for the month  The HFRI Macro Systematic Index, down 3.7% and  comprised of managers using computer generated signals to exploit inefficiencies and trends in the market, was the worst performing index tracked by HFR.

 

 

Absolute Return

 

While the broad hedge fund indices were negative, most absolute return oriented strategies realized positive returns during the month.  The HFRI Relative Value (Total) Index gained 1.5% in January.  Convertible arbitrage managers, the best performing strategy in 2009, returning 60.2%, were only slightly positive, up 0.5%.  The returns of convertible bond strategies continued to lessen, and in the future, should be dependent on security specific performance.  Non-traditional demand and the cheapness of new issuance, however, continued to be tailwinds.

 

The HFRI Relative Value Multi-Strategy Index was up 2.4%, as some short positions in CMBS benefitted managers.  One of the more highly publicized events was BlackRock’s default of Stuyvesant Town and Peter Cooper Village properties in Manhattan.  The 110 building and 11,000 apartment property complex was financed in 2006 at $5.4 billion and is now estimated to be worth $1.8 billion by ratings agency Fitch.  The properties should likely be a focus of several distressed debt and equity investors in the near-term.

 

Multi-strategy managers also profited from positions in distressed situations.  One such holding of many hedge funds is the post-bankruptcy equity of lender CIT Group, which rallied during the month.  CIT recently emerged from a  pre-packed bankruptcy of 40 days and voluntarily offered to prepay $750 million of its $7.5 billion first lien credit facility.  Managers specializing in distressed situations realized some of the strongest performance in January, as the HFRI Event Driven Distressed/Restructuring Index gained 2.0%.  The HFRI Event Driven (Total) Index returned 0.9% as managers realized gains in short positions of sovereign credit default swaps (CDS) in Europe, particularly as spreads widened in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain).

 

The HFRI Event Driven Merger Arbitrage Index was improved slightly, up 0.3%, as January was a relatively quiet month for deal flow activity.  Volume in the U.S. was $131 billion in January.  Total M&A activity in the U.S. hit a six-year low in 2009, but investors are encouraged by the 2010 pipeline.  Paul Parker, head of global M&A at Barclays Capital, commented, "We expect $2.1 trillion in 2010, but with more traditional M&A playing a larger role.  The numbers may look flat on paper, but when you take out a lot of the noise of [2009], it really indicates more traditional merger transactions and a healthier market.”  Lee LeBrun of UBS went on to say, "There are a number of factors which create a tailwind for M&A volumes to rebound:  CEO confidence is high, capital markets are accommodative, balance sheets are stronger with high levels of cash.  And given the interest rate environment, cash hasn't ever had a lower opportunity cost."  The majority of M&A activity should continue to come from sectors of the market with excess capacity, or flexible balance sheets with lower valuations, including health care, energy, and technology.