June 1, 2006

Saving Grace for Hedge Funds

Searching for Alpha, the monthly index newsletter for June 2006

Concerns over inflation and economic growth resulted in significantly lower equity prices in May. But it wasn't just stocks that got pounded. Virtually every type of asst class ended the month lower, including commodities, the U.S. Dollar Index, high-yield bonds, gold, and the energy complex. For the well-diversified investor, this is a worst-case scenario, as a host of uncorrelated investments all decided to head south at the same time.

In this type of environment, one might expect hedge funds to lead to the way down. After all, many of them are simply leveraged versions of traditional portfolios. As investment valuations dropped and correlations converged, the logical conclusion would be for a bloodbath for alternative investments.

That was indeed the case for a number of risk-seeking hedge fund strategies such as global macro. But for a host of lower volatility products, May was not as bad as one would expect. The saving grace for many of these funds was resiliency in domestic credit spreads. Even as stock and bond markets lost ground, the yield differential between government and corporate borrowing rates held steady. As a result, leveraged loan portfolios and other rate-sensitive holdings held up surprisingly well in a month characterized by red ink.

This is indicative of the extreme diversification many of the larger hedge funds are capable of achieving. As such diverse investments as plastic surgery receivables and home equity lines of credit are rapidly being securitized, investment pros with unfettered mandates have the ability to spread out risks in ways that were unimaginable just a few years ago.

The Monthly Index Report for June 2006

Index

May-06

QTD

YTD

Description
S&P 500 Index*

-3.09%

-1.91%

1.75%

Large-cap stocks
DJIA*

-1.75%

0.53%

4.21%

Large-cap stocks
Nasdaq Comp.*

-6.19%

-6.88%

-1.20%

Large-cap tech stocks
Russell 1000 Growth

-3.39%

-3.53%

-0.54%

Large-cap growth stocks
Russell 1000 Value

-2.53%

-0.05%

5.88%

Large-cap value stocks
Russell 2000 Growth

-7.04%

-7.31%

6.01%

Small-cap growth stocks
Russell 2000 Value

-4.14%

-3.88%

9.10%

Small-cap value stocks
EAFE

-3.76%

0.91%

10.46%

Europe, Australasia & Far East Index
Lehman Aggregate

-0.11%

-0.29%

-0.93%

U.S. Government Bonds
Lehman High Yield

-0.01%

0.61%

3.51%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-1.09%

1.33%

3.87%

Managed Futures
3-month Treasury Bill

3.88%

All returns are estimates as of May 31, 2006. *Return numbers do not include dividends. ** Returns are estimates as of May 30, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

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