MAY 2010

Risk appetite quickly shifted course and abated during May, as equities and corporate bonds posted large declines and investors favored the relative safety of government issues.  A confluence of negative events, which included the worsening oil spill in the Gulf of Mexico, political tensions between North and South Korea, the market “flash crash”, and the continued overhang of the debt crisis in Europe, were enough to spook investors and send markets reeling during the month.  While there is no doubt the U.S. has its own difficulties, Treasuries remained a safe haven alternative to areas facing austerity measures and political unrest.

As the VIX spiked to over 45, a 14 month high, the broad indices of the HFRI Fund Weighted Composite and HFRI Fund of Funds Composite were unable to garner positive performance.  Nevertheless, the HFRI indices were down significantly less than the 8.0% decline of the S&P 500, as the hedging nature of the funds’ short positions protected capital.  During the month, the HFRI indices were down 2.3% and 2.8%, respectively.  Hedge fund indices are now ahead of their traditional, long only equity comparisons for the year, as the HFRI Fund Weighted Composite returned 1.3% and the HFRI Fund of Funds Composite returned -0.5%.  The S&P 500 was down 1.5% for the year as of the end of May.

Directional

As the tumult of Europe and concerns over an economic slowdown in Asia sent markets lower in May, hedged equity managers aggressively reduced risk and cut market exposures.  Despite managers’ efforts to be nimble, the HFRI Equity Hedge (Total) Index declined 3.7%, its worst performance since the height of the credit crisis in November 2008.  The -3.7% return was effective in protecting equity investments, though, as it participated in less than one-half of the S&P 500’s decline of 8.0%.  This protection is critical to long term investing when considering the power of capital preservation and compounding returns.  For the year, the equity hedge index gained 0.3%.

Equity market neutral managers, those utilizing pair trades of long and short positions to offset market exposure, were not materially affected by the market gyrations and were up 0.2% for the month.  Managers’ short positions generally afforded greater returns than the losses realized by long positions, resulting in a 1.0% return year-to-date.  Prior to May, short bias managers were the laggards of all hedge fund strategies.  As expected with a backdrop of precipitously falling equity markets, however, short bias managers were the best performers during the month.  Short bias managers gained 7.0% as equity markets broadly fell across the globe, but declined 4.4% in May year-to-date.

Emerging market managers were the poorest performers in May, as Asian and Eastern European regions sold off in favor of safety.  The HFRI Emerging Markets (Total) Index fell 6.0%, compared to an 11.3% loss for the MSCI EAFE Index.  Hedge fund managers specializing in Asia ex-Japan were down 5.7% and those invested in Russia/Eastern Europe were down 10.0%.

Performance of Global Macro managers was mixed, as the index lost 0.9% in May.  Oil was a headwind for many hedge funds, as the commodity fell 14.1% in May, one of its worst months on record.  Trend following programs, such as managed futures and Commodity Trading Advisors (CTAs), were effective diversifiers and exhibited little to negative correlation to broad equity markets, realizing positive returns.  Shorter time frame programs were generally the best performers.  Also offsetting negative performance were positions designed to benefit from a flight to quality, which included gold, Treasuries, and the rallying U.S. dollar.  Gold was up 2.7% to $1212 per ounce, the yield on the ten-year Treasury narrowed 37 basis points, and the U.S. Dollar gained 7.4% versus the euro during the month.  Global macro is a strategy that should be favorably positioned to benefit from continued uncertainty surrounding political and macroeconomic events.

Absolute Return

Credit markets suffered a difficult May in response to deficit concerns in Europe and the unilateral move by the German Federal Financial Supervisory Authority to ban naked shorting on certain financial instruments.  The specific securities included in the ban were not so worrisome, as was the fear of an imprudent contagion by other countries to initiate similar regulations.  Other countries appear for the time being, however, to have realized the negative consequences of Germany’s judgment.  Corporate bond issuance also slowed to an anemic $70 billion during the month.  This was the lowest level of issuance in nearly seven years.

Returns for managers in the broad HFRI Relative Value (Total) Index declined 1.0%.  Within relative value, convertible arbitrageurs suffered losses, as the underlying equity in convertible bonds traded down in the market sell off.  Cheapness levels within convertible bonds have risen, however, and are again creating interesting buying opportunities.  Returns for convertible arbitrageurs were down 2.3% in May but up 2.6% for the year.  Multi-strategy managers with the ability to allocate to several strategies on an opportunistic basis, were down 1.6%, as there were few places to hide during the market’s plunge.  They remain positive for 2010, with a 4.8% return.

The HFRI Event Driven (Total) Index declined 2.2% in May.  Risk premiums on several widely held deals widened during the month due primarily to the increase in volatility and decline in the equity markets.  Deal spread widening created mark-to-market losses for managers specializing in risk arbitrage and merger arbitrage.  Deal flow for the month was down from April and remained muted at $132 billion.  This was the lowest monthly volume yet during 2010.  One notable deal announced during the month was the proposed merger between airlines UAL and Continental.  Managers focusing in merger arbitrage were off 0.9% in May and are up 0.9% for the year.