Morningstar sees 2 per cent gains for hedge funds in fourth quarter

Hedge funds in Morningstar's database, excluding funds of funds, returned an average of 1.98 per cent during the fourth quarter of 2007, outperforming the S&P 500 Index and the MSCI World Index in US dollar terms.

Overall hedge funds gained 14.13 per cent over the full year, according to Morningstar hedge fund analyst Nadia Van Dalen, despite the impact of the credit crunch in the second half of the year, notably in August and November, that prevented funds from building significantly on earlier gains.

Emerging markets equity hedge funds were the clear winners in 2007 with a 32 per cent annual return in US dollars, according to Morningstar, but the MSCI Emerging Markets Index outperformed the average hedge fund by more than 4 percentage points over the year. The data provider says that while emerging markets hedge funds on average best the index in November, they failed fully capture the sector's upside in September and October.

With a 16 per cent gain, global equity funds were the second-best performing category, returning about 9 percentage points more than their benchmark, the MSCI World Index and also outperforming the index in the fourth quarter.

Morningstar says US equity hedge funds posted a modest 0.3 per cent gain for the fourth quarter with but substantially outpaced the S&P 500 over both three and 12 months, while US equity small-cap funds gained 0.8 per cent in the fourth quarter and 13.6 per cent for the year, compared with a 1.6 decline for the Russell 2000 small-cap equity index.

European equity funds returned 14.1 per cent in 2007, including 0.3 per cent in the fourth quarter, while developed Asia funds declined 2 per cent over the quarter but finished up 6 per cent for the year. Short equity hedge funds took advantage of equity market turmoil to gain 6.2 per cent in the fourth quarter, rescuing full-year returns that ended up 7.8 per cent.

Global trend funds that systematically follow price trends in futures and currencies gained 6.5 per cent in the fourth quarter, more than any other category surveyed by Morningstar, and posted an annual return of 14.7 per cent, thanks in part to big movements in commodities such as gold and oil. Global non-trend funds that were able to exploit the falling dollar gained 4.3 per cent in the fourth quarter to finish the year up 14.9 per cent.

As credit conditions worsened in the second half of the year, corporate actions funds struggled to a 0.3 per cent gain in the fourth quarter, bringing their annual return to 8.5 per cent, while Morningstar says distressed securities funds have yet to benefit from the market turmoil, losing 0.5 per cent for the quarter to end up just 5.1 per cent for 2007 as a whole.

No hedge fund category surveyed by Morningstar lost money in 2007, but convertible arbitrage funds underperformed US Treasury bills, declining 2.1 per cent in the fourth quarter and gaining a mere 2.4 per cent return for the year as improving convertible issuance and volatility failed to compensate for widening spreads.

Debt arbitrage hedge funds rode the widening spreads to gain 1.5 per cent in the fourth quarter and end the year up 12.6 per cent, while equity arbitrage funds gained 2.9 per cent for the quarter and 12.4 per cent throughout 2007.

Multi-strategy funds underperformed the average single-manager fund, returning 13.4 per cent for the year and 2.9 per cent in the fourth quarter, but just beat funds of hedge funds, which gained 13.3 per cent in 2007 and 2.6 per cent over the final three months.

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