Year's Returns Dented, Not Reversed, by Tough Month

NEW YORK (HedgeWorld.com)--Major hedge fund sectors across the board lost heavily in the past month but not as much as market indexes, according to Merrill Lynch research. Year-to-date hedge fund returns remain significantly positive despite the down month.

The average of several diversified hedge fund indexes lost about 1% for the past month as of May 22, analyst Mary Ann Bartels showed in the Merrill Lynch report. Long/short equity lost 2.6%, macro funds lost 2.7% and managed futures 2.3%.

But year-to-date these strategies have gained 4.4%, 2.3% and 5.4% respectively, as indicated by the average of various indexes. Hedge funds as a whole made 3.8% for 2006.

U.S.-only long/short equity was the worst-performing group (for which data was available as of May 22). Convertible arbitrage and distressed credit are the only two sectors that notched positive returns for the past month.

Convertible arbitrage--interestingly, a strategy that investors have been deserting--was up 1.4% for the last 30 days and 4.7% for the year. That may be a result of large asset outflows, with the smaller amount of capital now in the convertible market allowing better deals for remaining traders.

For some managers, worse is yet to come. It's been a very tough month, said Ken Phillips, a hedge fund investor and managing principal at RCG Capital Advisors LLC. In particular he expects sharp drops in emerging markets portfolios, especially as such funds lean heavily to the long side of the market--short selling is relatively rare.

The impact of the emerging markets slump is not yet fully reflected in the data. Emerging market funds account for only a small part of industry assets but managers in other strategies have been attracted to these markets because of stellar profits in recent years.

As far as the U.S. market goes, Ms. Bartels argues that equities are now positioned to rally as the downward movement was primarily driven by hedge funds betting against the market. Hedge funds were selling stock indexes via futures and have crowded into a short position on the Nasdaq 100, she points out.

As shorts are covered, they give an upward bounce to the market. On that basis, she expects that the bull will resume its course. But she warns that in the first year of a new Federal Reserve chairman equities typically have higher volatility and lower returns.

A rally would benefit long-biased U.S. equity funds while hurting funds with short positions. But that is only one piece of the story--many hedge funds are exposed to international factors, including fluctuations in exchange rates.

CKurdas@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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