The Year in Hedge Funds

This summer, several high-profile hedge funds that invested heavily in securities tied to subprime mortgages collapsed, prompting a credit crunch that struck many big financial institutions. Rallying off strong global stock performance in early summer–the DJIA rose steadily through mid-July to reach more than 14,000 after a late-April high of 13,089–the CS/T Index returned 5.2% over the second quarter. In addition to strong stocks, many hedge fund sectors rallied on strong mergers and acquisitions activity and a positive overall economic outlook.

The third event was the statistical arbitrage sell-off caused by the need for bank proprietary trading desks and hedge funds to de-lever and then liquidate their positions due to investors’ uncertainty in a difficult third quarter. Accordingly, hedge fund strategies varied widely in their performance. Indeed, the CS/T index lost a combined 1.53% for the month of August, though short-selling funds initially capitalized on declining credit markets. Equity market neutral funds using stat arb suffered, as crowded trades caused widespread losses among quantitative funds with the same small-cap and midcap stocks in their portfolios. On the other hand, emerging markets, with limited credit market exposure, gained 5%. Overall, the CS/T Index was up 1.1% amid the turmoil.

The final major event was the return of the credit crunch. In November stock markets suffered their worst monthly performance in recent years as investors reacted to the U.S. housing downturn and the fear that the credit crunch increased the possibility of a recession. Global stock markets slipped as nearly $40 billion in paper losses was announced at large banks like Citigroup Inc. and Merrill Lynch & Co. However, all 10 hedge fund strategies in the broad CS/T index were in positive territory, and the index gained a combined 2% for the fourth quarter through November. Convertible arbitrage funds were flat, with a 0.5% gain.

In conclusion, despite increased borrowing rates, hedge fund financing is still available and allows for leveraging of positions in pursuit of alpha. While some hedge fund strategies suffered during 2007, “others capitalized on market turmoil, thereby more than compensating for the negative impact,” according to the report. Hedge fund strategies benefit from the diversification of a multi-strategy index like the broad index.