Index July 2003 QTD YTD Description
S&P 500 1.62% 1.62% 12.56% Large-cap stocks
DJIA 2.65% 2.65% 10.58% Large-cap stocks
Nasdaq Composite 6.91% 6.91% 29.91% Large-cap tech stocks
Russell 1000 Growth 2.49% 2.49% 15.90% Large-cap growth stocks
Russell 1000 Value 1.49% 1.49% 13.23% Large-cap value stocks
Russell 2000 Growth 7.56% 7.56% 28.35% Small-cap growth stocks
Russell 2000 Value 4.99% 4.99% 22.30% Small-cap value stocks
MSCI EAFE 2.16% 2.16% 12.07% Europe, Australasia & Far East Index
Lehman Aggregate -3.36% -3.36% 0.43% U.S. Government Bonds
Lehman High Yield -1.10% -1.10% 17.18% High-yield corporate bonds
Carr CTA Index -1.71% -1.71% 7.83% Managed futures
Through July 31, 2003.

At first glance, July’s market index returns don’t appear particularly ominous. With the S&P 500 up almost 2% and the Nasdaq surging nearly 7%, it might seem that the markets were fairly easy to navigate during the month. But for hedge funds, those unregulated investment partnerships that are gaining a larger foothold in the portfolios of ultra-affluent investors, nothing could be further from the truth.

The paltry performance of hedge funds in July has its roots in the bond market. After the June 25th Federal Reserve Open Market Committee meeting, many market participants were convinced that the Fed would enter into an aggressive policy of buying Treasury bonds in order to keep long-term rates low. As a result, many traders began amassing large bond positions, which pushed prices dramatically higher. When this scenario did not come to pass, many of these positions were unwound, which led to large losses in many fixed-income indexes.

There are two schools of thought about the bond selloff, which continued throughout the month. One group contends that rising yields are largely due to the expectation of greater economic growth in the second half of the year. Others believe the move by Greenspan was an effort to slowly deflate the bond market bubble. Whatever the cause, the effect was an astonishing 140 basis-point rise in 10-year yields in just six weeks

One of the first casualties of the bond meltdown was the corporate fixed-income market. With credit spreads widening, prices of corporate paper fell significantly. Increasing supply, led by General Motor’s massive $17 billion bond offering, also contributed to the weak tone of the market. Mortgage spreads also widened, leading to losses for many mortgage-backed securities hedge funds.

Convertible and high-yield bonds were adversely affected as well. After a tough June that witnessed the largest pullback for convertible arbitrage funds in a number of years, July did not offer any relief. Most of the problems are related to a softening in demand after a record $42 billion in new issuance in the second quarter. Rising dividends were also cited as a reason for weakness in the market.

The extreme volatility in the fixed income markets marked the end of a prolonged uptrend in interest rate futures. Although most trend-followers started making some profits with short positions in 10- and 30-year bonds late in the month, July will likely extend the drawdown in managed futures that started in June.

The inability of the alternative investment industry to capitalize on such a dramatic market move is largely due to the rapidity of the move. But that doesn’t mean that hedge fund managers are an inferior lot. After all, the last three times yields experienced a dramatic spike–in 1987, 1998, and 1994–mutual funds were ravished. It may not happen at once, but if bond prices keep dropping, all asset classes will eventually be affected.