Hennessee Hedge Fund Index advanced +5.68% in May (+11.40% YTD), while the S&P 500 increased +5.31% (+1.76% YTD), the Dow Jones Industrial Average advanced +4.07% (-3.14% YTD), and the NASDAQ Composite Index advanced +3.32% (+12.52% YTD). Bonds also rose, as the Barclays Aggregate Bond Index advanced +0.73% (+1.33% YTD), according to Hennessee Group LLC, a consultant and adviser to direct investors in hedge funds.
Hennessee Group research and discussions with hedge fund managers has lead the Hennessee Group to believe that the 20 year secular bull market in bonds is over. Interest rates on the 10 Year Treasury have come down from 9% to 2% over that period. In addition, over the past two decades, the Barclays Aggregate Bond Index has returned an annualized +7.37% per year vs. +5.40% for the S&P 500, says Charles Gradante, co-founder of Hennessee Group.
We see a problem growing in the bond market. The Government is issuing more debt than it is buying back. This has to lead to rates increasing and equity PE ratios adjusting downward. Our contacts among hedge fund managers continue to buy gold and short Treasuries. However, Hennessee Group expects the Treasury and Fed to put a short squeeze on at an opportune time.
The Hennessee Long/Short Equity Index gained +5.23% in May (+10.13% YTD). Long/short equity managers slightly underperformed the S&P 500 while maintaining reduced exposure levels and hedges. Managers have been maintaining a conservative investment strategy, which has caused them to lag in the recent market rally.
In May, funds also benefited from long positions in energy and commodity-related positions, which performed strongly. With the equity markets up more than +25% from their March bottom and without real economic fundamental improvement, managers remain bearish and are defensively positioned. However, managers are attempting to balance a fear of not participating in the market rally with real concerns about long term fundamentals. As a result, managers are focusing on keeping portfolios extremely liquid realizing that they may need to change positioning quickly.
With hedge funds up +5.68%, May was the best month for hedge funds since February 2000, when the index was up +6.83, says Lee Hennessee, managing principal of Hennessee Group. Gains were largely driven by arbitrage strategies. However, long/short equity managers, with reduced levels of exposure, also performed well, participating significantly in the market rally while maintaining hedges. With a market correction in the short term being a possibility, we feel that most hedge funds are positioned conservatively and will be able to quickly alter exposures to protect capital if the market experiences a correction.
The Hennessee Arbitrage/Event Driven Index gained +6.01% in May (+14.51% YTD). The credit markets, especially high yield and distressed bonds, experienced another month of strong performance, driven primarily by improvements in the primary market. The spread on the Merrill Lynch High Yield Index over 10-Year Treasury tightened from 1345 basis points to 1170 basis points during May and is down from close to 2000 basis points six months ago. The Hennessee Distressed Index advanced +5.35% in May (+13.47% YTD) due to spread tightening, a positive carry and event opportunities, specifically GMAC and MGM.
The Hennessee Convertible Arbitrage Index advanced +8.61% (+25.67% YTD), and remains the top performing hedge fund index for 2009. Credit spreads were the largest performance driver while lower equity volatility slightly weakened returns. The VIX index closed below 30 for the first time since September 2008. New issuance has come back to life as the primary market raised $6 billion, which is a positive sign for the strategy. Financing conditions have also improved, allowing for funds to add moderate leverage.
The Hennessee Merger Arbitrage Index advanced +1.29% in May (+3.96% YTD). Managers continue to focus on strategic deals and potential acquisition targets. The ability of companies to obtain financing has improved slightly, which is a positive for M&A outlook. Spreads remain wide as competition has declined and risk aversion remains elevated.
Arbitrage strategies have benefited substantially from the significant tightening of credit spreads. High yield spreads have tightened almost 1000 basis points in the last six months and still remain well above their long term average, says Charles Gradante. While credit related strategies have benefited, we expect the corporate default rate to continue to increase through 2009. While distressed debt has been a top performer in 2008, we feel the outlook for 2009 and 2010 is very positive as distressed typically generates its best gains after default rates peak.
The Hennessee Global/Macro Index advanced +6.17% in May (+10.05% YTD). Gains were driven by very strong performance in emerging markets and Asia-Pacific regions. International equities were up sharply again in May as investors continued to shift money to riskier assets, with the MSCI EAFE Index advancing +11.09% (+6.45% YTD). The BRIC countries (Brazil, Russia, India and China) were sources of profits for managers as these markets were up a collective +23% in May. The Hennessee International Index advanced +4.88% (+7.45% YTD) as managers remain generally conservative.
The Hennessee Macro Index advanced +4.69% for the month (+7.92% YTD).
Managers benefited from a common reflation trade, where they are long commodities and short Treasuries. Both sides of the trade worked well as commodities advanced +13.79%, their best month since 1974. Treasury prices declined as the yield on the 10 Year Treasury increased from 3.16% to 3.47% during the month. Managers remained concerned about the U.S. dollar as current fiscal and monetary policy may lead to a debasing of the currency and significant future weakness.
May had the biggest one month run up in commodities in 35 years, continues Charles Gradante. It appears to us, from Hennessee Group research and manager conversations, to be speculative and led by commodity ETF demand, which exceeds “real” demand. Furthermore, margin requirements favor the speculators. Hedge funds are betting commodities will continue to rise with many long agriculture commodities, such as sugar and corn.
L.D.