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Hedge funds lag as equity market rally continues, says Hennessee Group

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The Hennessee Hedge Fund Index advanced 1.85 per cent in August, bringing year-to-date performance to 17.30 per cent, according to Hennessee Group,  a consultant and adviser to dir

The Hennessee Hedge Fund Index advanced 1.85 per cent in August, bringing year-to-date performance to 17.30 per cent, according to Hennessee Group,  a consultant and adviser to direct investors in hedge funds.

The S&P 500 increased 3.36 per cent (12.99 per cent YTD), the Dow Jones Industrial Average increased 3.54 per cent (8.20 per cent YTD), and the Nasdaq Composite Index advanced 1.54 per cent (27.40 per cent YTD). The Barclays Aggregate Bond Index advanced 1.04 per cent (4.62 per cent YTD). 

‘There was good economic news released in August, specifically housing and manufacturing data. However, our expectations for future growth and a V-shaped recovery are tempered. Government spending continues to drive demand, while the private sector has been largely absent. This dynamic is not sustainable,’ says Charles Gradante, co-founder of Hennessee Group. ‘In addition, equity markets are no longer undervalued. The P/E ratio for the S&P 500 Index has gone from a March low of 10x to over 18x during the month of August. With September being one of the worst months historically, we are cautious of a pull back in the markets.’

The Hennessee Long/Short Equity Index gained 1.88 per cent in August (15.27 per cent YTD). The US equity markets continued their upward momentum in August boosted by positive economic data, particularly in the US housing market and manufacturing sector.

Financials were the primary driver of the equity markets, up a strong 12.9 per cent in August. Financials gained support during the month on news several hedge fund managers were beginning to build significant equity positions in the financial sector, particularly Citigroup, which jumped 57 per cent during the month. 

Many managers are also focusing on ‘franchise-type’ businesses that have strong free cash flow, solid balance sheets, pricing power and the ability to increase market share. Going forward, managers will remain cautious with their exposures across sectors and rely largely on individual security selection as it is widely believed the market has gotten ahead of itself in recent months and is due for a correction. 

‘We have seen a steady rise in US manufacturing levels over the past several months, which is certainly a positive sign,’ says Gradante. ‘However, a lot of this is being driven by government stimulus and subsidies, such as the ‘cash-for-clunkers’ programme. I am also concerned that the increase in manufacturing activity may be largely due to a weaker dollar, which makes exports more attractive. Thus, the manufacturing data may be more reflective of the currency situation rather than an actual resumption of growth.’

The Hennessee Arbitrage/Event Driven Index gained 2.10 per cent in August (19.89 per cent YTD). Positive contributions were wide spread with credit-related and convertible arbitrage strategies performing strong and merger arbitrage generating consistent, modest gains. Credit markets continued their strong rally with high grade returning 2.2 per cent, its fifth straight positive month, and high yield returning 2.0 per cent, its sixth straight positive month. 

The spread on the Merrill Lynch High Yield Index tightened further from 922 basis points to 912 basis points during the month, hitting a low of 857 basis points during the month. 

The Hennessee Distressed Index advanced 2.58 per cent in August (24.40 per cent YTD). Distressed positions continued to benefit from the rally in credit. Managers remain optimistic on the opportunity set for the strategy and expect continued defaults. They report that the maturity schedule of bonds in the US will require an acceleration of refinancing activity starting in 2011 with the credit markets needing to absorb USD1trn in high yield refinancing over the next five years.

The Hennessee Convertible Arbitrage Index advanced 2.96 per cent (34.53 per cent YTD). Spreads, interest rates and buying in the secondary market made positive contributions. Redemptions remained high in August, with buybacks and tender offers accounting for almost 75 per cent of the redemption volume. Managers also report that competition among prime brokers is increasing, and funds are seeing improvements in financing terms. 

The Hennessee Merger Arbitrage Index advanced 1.18 per cent in August (6.20 per cent YTD). Positive performance was largely from pharmaceutical risk arbitrage deals, which benefited from modest spread tightening. Managers state that spreads should continue to tighten as liquidity continues to increase. However, greater liquidity should also lead to a pick up in activity.

‘We agree with the consensus view that emerging markets will be the major driver of global economic growth for the foreseeable future,’ says Gradante. ‘Thus, we are optimistic on emerging market strategies. However, we are cautious on China, which experienced a significant decline in August. We have some concerns that China’s stimulus was driving excessive valuations in the stock market.’

The Hennessee Global/Macro Index advanced 1.87 per cent in August (18.19 per cent YTD). Global equities rallied as the MSCI EAFE Index advanced 5.16 per cent (21.14 per cent YTD), driven largely by European markets. There are now clear signs that the global financial system has stabilized and a recovery is underway. The concern now becomes the extent to which it is priced into equity markets and what kind of recovery will unfold.

The Hennessee International Index increased 1.83 per cent (14.51 per cent YTD). Emerging markets displayed weakness, especially China, which officially entered a bear market as markets declined more than 20 per cent in August. Many are concerned about the quality and sustainability of the Chinese stimulus program.

Managers are expecting considerable macro uncertainty with markets likely to experience volatility. The Hennessee Macro Index advanced 0.83 per cent in August (9.06 per cent YTD). The ‘reflation trade’ (long commodities against short Treasuries) is still widely held among macro managers. 

Managers continued to generate gains in metal positions as industrial metals, silver and zinc performed well and more than offset losses from increases in Treasuries. The two-year Treasury yield dropped from 1.13 per cent to 0.98 per cent, and the ten-year Treasury yield fell from 3.50 per cent to 3.40 per cent. At the same time, the 30-year Treasury yield decreased from 4.31 per cent to 4.18 per cent.

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