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Hedge funds decline 2.99 per cent in May

The Hennessee Hedge Fund Index declined by 2.99 per cent in May, bringing its year-to-date return to 1.57 per cent.

The S&P 500 decreased 8.20 per cent (-2.30 per cent YTD), the Dow Jones Industrial Average declined 7.92 per cent (-2.79 per cent), and the Nasdaq Composite Index fell 8.29 per cent (-0.53 per cent YTD). 

Bonds advanced, as the Barclays Aggregate Bond Index increased 0.84 per cent (+3.74 per cent YTD), due to increases in U. Treasuries as both investment grade and high yield bonds declined.

“May was the worst month of the year for hedge funds and the worst monthly drawdown since October 2008.  However, hedge fund managers avoided significant losses and outperformed traditional benchmarks on a relative basis due to conservative exposures, hedging and short positions,” says Charles Gradante, co-founder of Hennessee Group. “In May, we saw investors significantly de-risk portfolios as volatility increased. Given the negative headwinds that exist and potential global crises, hedge funds continue to operate with low gross exposure levels as they navigate an increasingly challenging investment environment.”

The Hennessee Long/Short Equity Index declined 2.81 per cent in May (+1.66 per cent YTD). The equity market “flash crash”, the downgrade of European debt ratings, the Gulf oil spill, and the escalating tensions in Korea, spooked investors and triggered a flight to quality, namely US Treasuries. The equity markets experienced a sharp, broad based sell-off, giving back all of 2010 gains and leaving most indices in the red for the year. 

All ten S&P sectors were in the red, led down by the energy sector (-11.8 per cent) as the BP oil spill put heavy downward pressure on energy stocks. Managers also lost money in the financial sector, as worries about European sovereign debt hammered financial services stocks. 

While hedge funds struggled to generate positive returns for investors given the broad based sell-off during the month, they still managed to outperform the broader indices on relative basis by a significant margin. Managers who were quick to trim exposures at the first sign of volatility fared better, with some funds able to squeeze out modest positive gains.

In light of the ongoing macro issues and heightened volatility, hedge funds continue to reduce risk and remain cautious. The emphasis among hedge funds remains high quality, non-cyclical, defensive companies with low valuations, strong earnings growth and capital flexibility. 

The Hennessee Arbitrage/Event Driven Index declined 2.62 per cent in May (+3.71 per cent YTD). As the equity and credit markets declined in May, arbitrage strategies also fell, brought down by event driven, distressed, credit and convertible arbitrage strategies. 

Credit spreads widened due to concerns about the European government’s sovereign debt issues, with the spread on the Merrill Lynch High Yield Index widening from 561 basis points to 598 basis points during the month, after hitting a high of 724 basis points mid-month. The Merrill Lynch High Yield Master II Index fell 3.52 per cent (+3.39 per cent YTD).

The Hennessee Distressed Index declined 4.87 per cent in May (+4.85 per cent YTD). Distressed funds suffered losses due to declines in the equity and credit markets and the overall flight to quality. Due to their traditional net long bias, distressed funds typically experience losses in a downturn if there is a lack of specific catalysts. Despite the downturn in May, managers are still seeing ample long and short opportunities in distressed situations and dislocated assets. Managers are active in acquiring assets from banks and other lenders that continue to sell off assets in order to clean up balance sheets. 

The Hennessee Merger Arbitrage Index also declined by 1.04 per cent in May (+1.29 per cent YTD). Spreads widened due to an increase in volatility and the market decline. Managers are also optimistic for M&A due to the fact that companies have record amounts of cash on their balance sheets. 

The Hennessee Convertible Arbitrage Index declined 3.00 per cent (+2.08 per cent YTD) in April. Wider spreads and secondary market cheapening detracted from performance, while volatility and interest rates made positive contributions. Managers report that the convertible space faced downward pressure due to dumping of convertible positions by European holders. A number of accounts lost money on currency hedges due to the fall in the euro, and were facing erosion of their equity and the fear or reality of investor redemptions. Managers also optimistically state that the convertible space is not as vulnerable as it was in 2008 because there is less leverage being employed, less paper in vulnerable holders, and steady participation by crossover buyers.

“I cannot remember when there have been so many potential ‘global crises’ happening at the same time,” says Gradante. “We have the oil spill in the Gulf of Mexico, the downgrades of the European PIIGS, altercations in the Middle East and Korean Peninsula, and concerns about Chinese monetary policy.  In addition, domestically, we are facing greater uncertainty regarding regulation of markets, massive US government debt, significantly higher taxes and the withdrawal of Federal stimulus. There are many things keeping hedge fund managers awake at night, and as a result, managers are operating with lower gross exposure levels.”

The Hennessee Global/Macro Index fell 3.50 per cent in May (-0.65 per cent YTD). International equities declined significantly as the MSCI EAFE Index fell 12.06 per cent (-13.72 per cent YTD) during the month. Global indices declined due to continued concern over the Eurozone, despite a EUR110bn bailout from the area and additional stated support from the IMF. 

In the emerging markets, uncertainty over policy tightening in China and the prospect of conflict in Korea hurt performance in the emerging markets. Hedge funds benefited from reduced international exposure and defensive positioning, as the Hennessee International Index fell 4.02 per cent (+0.38 per cent YTD).  The Hennessee Macro Index fell 0.79 per cent for the month (+1.22 per cent YTD). 

Gold was one of the few positive performers for the month, as investors remain concerned over currency instability and inflation in emerging markets. Managers lost money on short Treasury bets, which has been a consensus theme for some time. The two-year Treasury yield fell from 1.10 per cent to 0.75 per cent, the ten-year Treasury yield fell from 3.66 per cent to 3.31 per cent, and the 30-year Treasury yield dropped from 4.53 per cent to 4.23 per cent. Some managers have been forced to cover this trade as it appears that rates may remain low for longer than anticipated. Managers experienced losses on currency trades, as many were forced to finally cover short dollar bets. Several managers, who lost money in commodities, used the sell off to add to core positions at attractive entry points.

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