Hedge Funds Down in October - Hennessee Group

October proved tough for hedgies, with funds having their first down month in seven months. The Hennessee Hedge Fund Index declined -0.50% during the month (+20.12% YTD), while the S&P 500 fell -1.98% (+14.72% YTD), the Dow Jones Industrial Average was unchanged (+10.67% YTD), and the NASDAQ Composite Index declined -3.64% (+29.68% YTD). The Barclays Aggregate Bond Index advanced +0.49% (+6.24% YTD).

“After seven months of positive gains in the equity markets, the liquidity driven rally showed signs of weakness,” said Charles Gradante, co-founder of the Hennessee Group.

“So far, this rally has been driven by multiple expansion. We need to see earnings growth for the rally to be sustainable. This should be a good environment for hedge funds, as greater dispersion and volatility among industries and companies will benefit fundamental security selection in both long and short portfolios.”

“Hedge funds were down along with equity markets in October. Sectors that had driven performance, including tech, healthcare and financials, were hit especially hard,” said Lee Hennessee, managing principal of the Hennessee Group.

“Some managers had increased net long exposures in recent months to participate in the market rally. There is currently a dichotomy among funds that are defensively positioned, anticipating a market correction, and those that want to participate in a potential fourth quarter rally.”

The Hennessee Long/Short Equity Index fell –1.39% in October (+17.07% YTD). The equity markets retreated in October despite better than expected earnings reports and encouraging economic data. Small cap stocks were particularly weak in October, hurting hedge funds, as the Russell 2000 Index fell -6.9%. Biotech stocks were another area of weakness with the NASDAQ Biotechnology Index down -9.9% in October led down by Amylin (-19.4%) and Biogen (-16.6%). Despite their cautious stance, hedge funds struggled to generate positive results during the month as gains on their short positions were unable to offset losses in their long books. According the Hennessee Group, going forward, hedge funds will remain defensive as valuations remain stretched and numerous headwinds exist that could slow the pace of the global economic recovery.

Meanwhile, the Hennessee Arbitrage/Event Driven Index gained +0.81% in October (+24.45% YTD). Arbitrage and event driven funds outperformed long/short equity funds as credit and merger spreads continued to tighten.

The Hennessee Distressed Index advanced +1.43% in October (+30.13% YTD). Distressed funds have benefited this year due to their directional bias. Default rates have started to ease and several sell side research firms are forecasting lower default rates in 2010. However, managers report that there remains over $1 trillion in high yield maturities over the next 5 years, and remain optimistic on classic distressed investing.

The Hennessee Convertible Arbitrage Index advanced +1% (+40.74% YTD). Spreads made a positive contribution to convertible portfolios, while volatility, market cheapening and interest rates were negatives.

The Hennessee Merger Arbitrage Index advanced +0.30% in October (+7.11% YTD). Managers continue to be very active in large strategic deals, especially pharmaceutical deals. Hedge funds and proprietary trading desks have increased exposure causing spreads to compress. Most managers expect M&A activity to pick up and will look to increase their portfolio allocations to the strategies, especially as other strategies become less attractive.

“We expect to see merger and acquisition activity accelerate over the next 12 to 18 months. Credit markets are more accommodative, and companies will pursue strategic acquisitions to achieve growth,” said Gradante.

“However, currently, as hedge funds and other players have become more invested, existing deals are no longer as attractive as they once were. That said, there are still several large, liquid deals that are offering 5% to 8% annualized spreads on an unlevered basis.”

The Hennessee Global/Macro Index was essentially flat in October, down -0.12% (+21.15% YTD). Global equities declined as the MSCI EAFE Index declined -1.29% (+23.87% YTD), with developed markets driving negative performance.

The Hennessee International Index declined -0.91% (+17.73% YTD). Managers made money in emerging markets, particularly China, which released positive economic data, and Brazil, which saw large foreign inflows.

The Hennessee Macro Index fell -1.20% in October (+8.66% YTD). Managers lost money on the short dollar trade, which is pretty widely held. While the dollar rallied in October versus most major currencies, most agree that the long term trend for the dollar is going to be negative. Managers also suffered losses long the equities of developed markets, which experienced a correction. Managers made money in gold, which is another common theme as a hedge against the dollar and inflation. Managers also made money in fixed income as the yield curve steepened. The 2-year Treasury yield eased from 0.96% to 0.90%, while the 10-year Treasury yield edged higher from 3.31% to 3.41% and the 30-year Treasury yield fell from 4.03% to 4.23%.

“Macro managers are quite focused on the fixed-income markets,” said Gradante. “At some point, we are going to see central banks reverse their quantitative easing efforts. The consensus is still short long-term U.S. Treasuries as yields are too low to attract foreign buying.”

Comments

[Mad Hedge F...:]

nds The hedge fund industry is still emerging from the ashes of 2008, but will inevitably grab a larger share of the investing public’s assets. Low interest rates and hero status made it way too easy for inexperienced, untested, and sometimes unscrupulous managers to raise new funds that charged management fees as high as 3%, with a 50% performance bonus. Behind every “liar loan” was a bond manager happy to soak it up through securitized Fannie Mae (FNM), Freddie Mac (FRE), or bank debt, shorting Treasuries against them, and then leveraging the 40 basis point spread 50 times to generate a highly marketable 20% annual gross return. Never mind the risks. It was easy money, as long as there were lots of liars- which mortgage brokers herded in by droves, and as long as spreads narrowed-which they did for most of the 21st century. By the beginning of 2008, assets under management soared to $2 trillion. The melt down that followed wiped out large numbers of funds, and raised gates for the survivors, making investors wonder if they would ever get their money back. Total assets plunged to $1 trillion in the blink of an eye through a combination of redemptions and market losses. The new era that is emerging will be populated with humbled and chastened managers offering more disclosure, lower fees, no gates, and thanks to Madoff, oodles of third party oversight. Their portfolios will have less leverage, be invested in more liquid securities, and bring in lower returns. But the new generation will also offer investors battle tested strategies that survived the 100 year flood. Bridgewater, with $37 billion in assets, is now the largest hedge fund, followed by JP Morgan with $36 billion, Paulson & Co. at $27 billion, DE Shaw showing $26 billion, and Soros still at a hefty $24 billion. Long track records and a Gucci cachet will assure that these will prosper. Fees will settle down to the 1%/20% range. For the rest of us this means more capital bunching up in the most successful trades, as we have already seen this year in financials, China, oil, copper, and the multitude of short dollar plays. It is also going to be much harder to get new fund launches off the ground.

Nov 09 12:43 PM

[woollyB:]

This is no surprise, as the majority of hedge funds don't really hedge, they just buy. That's why they got wiped out in 2008, and it's why the market's tiny setback in October also set the hedge funds back. The more interesting point is how dramatically the hedge fund index has underperformed the across the board rallies this year.

Nov 09 07:43 PM