The Hennessee Hedge Fund Index advanced 1.30% in April (up 4.61% YTD), while the S&P 500 increased 1.48% (up 6.42% YTD), the Dow Jones Industrial Average advanced 1.40% (up 5.57% YTD), and the NASDAQ Composite Index advanced 2.64% (up 8.46% YTD).
Bonds also advanced, as the Barclays Aggregate Bond Index increased 1.04% (up 2.84% YTD) and the Merrill Lynch High Yield Master II Index increased 2.24% (up 7.17% YTD).
“While fundamentals, such as corporate earnings and economic data, have been surprisingly good in the first quarter, the market technicals after the ‘May 6th rout’, including support levels and moving day averages, are creating significant concern among hedge fund managers,” says Charles Gradante (pictured), co-founder of Hennessee Group. “The question is if this is a good entry point for bulls, or if this is just the beginning of a whole lot of pain. Most feel it is too early to tell and are operating with caution.”
Lee Hennessee, Managing Principal of Hennessee Group, adds: “Hedge funds have underperformed during the first four months of 2010, but I think that is expected. The market has experienced strong beta-driven rallies, especially in March, and it is common for hedge funds to lag. The short portfolios of hedge funds have been a major detractor from performance. Despite that fact, managers see elevated risk in the market, and are willing to sacrifice upside participation for down side protection. That should have served them well during the first week of May.”
The Hennessee Long/Short Equity Index advanced 1.43% in April (up 4.59% YTD). Despite a late month sell-off due to growing sovereign debt concerns and the SEC’s civil suit against Goldman Sachs, the equity markets finished the month of April higher. Small cap stocks continued to lead the equity markets higher with the Russell 2000 Index jumping 5.59%; the index is now up a strong 14.58% for the year. Seven out of ten sectors were positive for the month, led by consumer discretionary (+6.0%) and energy (+4.4%), while the more defensive sectors continued to lag, namely health care (-3.9%) and consumer staples (-1.6%).
Long/short equity funds slightly underperformed on a relative basis during the month due to their defensive posturing. Despite improving near term sentiment due to impressive earnings numbers and improving economic data, long/short equity fund managers remain cautious as they see numerous headwinds for both the economy and financial markets, particularly in the second half of the year, and will therefore continue to sell into any equity market strength to further reduce net long exposures. In addition, they will continue to emphasize fundamental, bottom-up stock selection as they strongly believe the market will shift from a low quality, beta driven market to one rewarding large cap, high quality stocks with sustainable earnings.
“Shorting has been extremely challenging this year," says Gradante. "Many hedge funds have actually generated negative alpha on their shorts (meaning that their shorts are going up more than the market). Funds have significant short exposure in high beta, low quality stocks, which have outperformed in this rally. Many funds have been badly burned on short bets in regional banks (up 42% YTD) and REITs (up 19% YTD), as these stocks continue to rally despite deteriorating fundamentals and significant headwinds.”
The Hennessee Arbitrage/Event Driven Index advanced 1.70% in April (up 6.26% YTD). During the month, equity and credit markets continued to rise, helping arbitrage and event driven strategies generate profits. Credit markets continue to benefit from improving corporate earnings, declining default rates, rising recovery rates and significant inflows.
High yield posted another strong month as the Merrill Lynch High Yield Master II Index gained 2.24% (+7.17% YTD) for the month despite volatility brought on by sovereign risks in Europe. The spread on the Merrill Lynch High Yield Index tightened from 584 basis points to 561 basis points during the month, hitting a low of 542 mid-month before widening at month end.
The Hennessee Distressed Index increased 4.13% in April (+11.71% YTD). Distressed funds continue to benefit from improving credit markets as well as company specific events. Managers are still seeing ample long and short opportunities in distressed situations and dislocated assets. Many are looking forward to 2012 to 2014 when a daunting corporate maturity schedule should prove problematic to refinance and will provide investment opportunities.
The Hennessee Merger Arbitrage Index was essentially flat, -0.02% in April (+2.22% YTD). As deal flow continues to accelerate, managers are getting more active.
Spreads have contracted over the last 12 months with friendly, uncomplicated deals trading at less than 10% annualized spreads. However, managers report profits in several hostile and/or competitive bidding situations and expect this trend to continue.
Managers are also optimistic for M&A due to the fact that nonfinancial companies in the S&P 500 have a record $830 billion of cash on their books, according to a Strategas report. The Hennessee Convertible Arbitrage Index returned 2.19% (+5.76% YTD) in April.
Portfolios benefited from tightening credit spreads, a pick up in volatility, lower interest rates and a positive carry on convertibles, while secondary market cheapening detracted from performance. Managers report that traditional and outright buyers are still active in the convertible space, providing trading opportunities for hedge funds.
“Managers believe that a significant portion of corporate maturities that come due in 2012 to 2014 are going to be problematic to refinance,” says Gradante. “With regards to the bank debt maturity schedule, 85% of all leveraged loans still outstanding are scheduled to mature by 2014. According to JP Morgan, approximately USD1.2 trillion of high-yield bonds and bank loans are scheduled to mature by 2015. Issuance would need to average USD200 billion a year in order to satisfy refinancing needs alone. In 2009, issuance was USD147 billion, setting an annual record. This should lead to significant financial distress and opportunities.”
The Hennessee Global/Macro Index increased 0.80% in April (up 2.99% YTD). International equities declined as the MSCI EAFE Index fell 2.10% (down 1.88% YTD) during the month. European markets fell due to fears over debt problems in Greece. The EU and IMF proposed a EUR110 billion bailout; however, political unrest in Greece caused markets to decline further as strikes and riots broke out in response to the planned spending cuts.
China was another source of losses, as equities declined due to policy tightening. China raised reserve requirements for banks for the third time this year at month end.
Managers benefited from reducing international exposure going into April, as the Hennessee International Index fell only 1.69% (up 4.34% YTD). The Hennessee Macro Index declined 0.36% for the month (up 2.19% YTD).
Managers gained in gold as a flight to quality led gold spot prices to increase by 5.94%. Also, many managers have been long oil, which increased 2.85% (up 8.56% YTD) in April, amid news of severe oil spill in the Gulf of Mexico. Managers experienced losses in short Treasuries positions as increased concerns about Greece and China caused a flight to quality, driving Treasury prices up and yields down.
“Hedge fund managers are increasingly concerned about stunted growth in China. Beijing, once intent on boosting China’s economy, is making a painful turn. Interest rates are increasing, lending standards are harder to meet, and credit growth has been stunted,” says Gradante. “In addition, managers have concerns in Europe. Unlike the American financial system, that can provide immediate liquidity through the Fed and Treasury actions, the EU has structural issues in that they lack the equivalent infrastructure resulting in major ‘meltdown’ risks.”
