Wednesday, 2 June 2010

Rough May and YTD for Domestic Equity Hedge Funds

Equity markets have been a switchback this year – a series of rises and troughs like a sinewave. The markets had a normal interim correction after a good start to January. The correction took equity markets down nearly 10% at the low in early February, and then we had a rally of above-average strength – a gain of nearly 17% in two-and-a-half months.

The Euro and commodity inspired fall since the start of May has been very aggressive to the downside. As is typically seen, volatility has risen with falling prices from as low as 5% on 10 day basis to over 30% currently. Share prices fell 8.2% in the calendar month.

At the aggregate level, looking at hedge fund indices as a proxy, and for equity hedge funds as a whole, the equity market background has been perfect to trap equity hedge fund managers. Hedgies tend to manage their balance sheet (net and gross) on the feedback their P&L gives them about their current positioning. As the P&L gets more positive the net fund exposure bias tends to be reinforced the same way, and vice versa.

Of course, some managers are skilled market-timers and they will add value for their investors by raising and cutting the net exposure to markets around turning points, or adding aggressively to exposures in trending markets. But such market timers are a rarity, and as there are over four thousand equity hedge funds in the United States it is fair to say that the typical hedge fund manager there will not have enjoyed this year’s markets because of the directional changes.

Hedge Fund Research of Chicago tracks equity hedge fund returns of domestic (US based managers) via a daily-priced investible hedge fund index. The HFRX Index for Equity Hedge Funds was up 1.29% from the end of 2009 to the end of April, compared to the S&P500 up 6.4% (ex dividends). So far so dull.

But May was extremely difficult for equity hedge funds on the back of rising net exposures – created because of a trending market from mid-February to mid-April. The HFRX Index for Equity Hedge Funds lost 3.4% in May, putting the year-to-date return at the hedge fund index level at minus 2.1%.

This is the index level return, around which there will be a particularly wide dispersion of performance delivered from individual hedge funds. So expect May 2010 returns from equity hedge dedicated to US markets to be anything from +2% to -7%. Emerging market equity hedge funds and those in Asia will have done worse than -3.4% on average in May. Ouch..

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