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Long/short equity managers benefit from shift to defensives

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Long/short equity managers who maintained a cautious stance through the recent market run-up appeared to be positioned to profit as markets shifted from cyclicals to defensives in June,

Long/short equity managers who maintained a cautious stance through the recent market run-up appeared to be positioned to profit as markets shifted from cyclicals to defensives in June, according to a report from Credit Suisse.

Overall, the Credit Suisse/Tremont Hedge Fund Index finished up 0.43 per cent for June, bringing year to date to 7.18 per cent.
 
The markets shifted from cyclicals (miners, energy stocks and consumer discretionary) in favour of defensives (healthcare, utilities and consumer staples), benefiting long/short equity managers who were more defensively positioned and who had missed the gains from the global equity rallies.

Although the markets generally moved sideways in June, second quarter performance for several key benchmarks was the best since late 1998, with the S&P 500 gaining 15.9 per cent in the three months, and the MSCI World gaining19.7 per cent.

Overall, emerging markets finished the month relatively flat despite a rebound in economic activity in Asia, as countries across the region saw rising industrial and manufacturing output. In China, the PMI index for manufacturing rose in June, while in India the current account moved into a surplus.

However, markets did not participate fully in the strength of the economic and fiscal recovery, as many investors consolidated their holdings and took profits. Russia’s Micex Index was the notable outlier on the downside, dropping more than 20 per cent from its 2009 peak, and became the first benchmark equity index to technically enter a bear market since global stocks began rallying in March. Nonetheless, the Micex was up 43 per cent for the quarter, the Bombay Stock Exchange’s benchmark Sensitive Index was up 49 per cent on the quarter, while Brazil’s Bovespa was down 3.3 per cent in June, but up 26 per cent for the quarter.

Credit markets showed healthy activity, with USD102bn of investment grade bonds brought to the market in June, and with the first half of the year total high grade issuance coming in at USD621bn, which is slightly less than the full year total for 2008.

Government activism in the markets continued in Europe, as the European Central Bank provided EUR442bn in 12-month loans to financial institutions at a rate of one per cent to boost liquidity. Many believe this could provide opportunities for credit-oriented hedge fund managers and to facilitate carry trades. In the US, the Fed continued its zero interest rate policy because of the mixed economic macro data.

Relative value managers posted positive performance overall as yields dropped and spreads tightened as a rule.

In the US, the Treasuries yield curve experienced a bearish flattening with a sharp sell off in the front end of the curve in the first week of the month (which reversed later), while a sell off on the longer end of the curve drove yields down. The volatility was driven by a tug-of-war between two investor camps: those anticipating an inflationary regime versus those anticipating deflation.

The sell-off of short rates in US Treasuries negatively impacted the positions of a number of global macro hedge funds early in the month, although many managers recovered when the yields returned towards prior levels. This was the first month since October 2008 that the global macro strategy had a negative monthly performance.

Convertible arbitrage led the index in monthly performance with a 4.1 per cent return, its sixth straight positive month, which brought it to 23.95 per cent year-to-date. Certain managers began to profit again from the volatility arbitrage aspect of the strategy on the back of the three-month recovery of equity markets starting in March, whereas earlier in the year the strategy received more attention as a credit play, given the devaluations many convertible bonds experienced in the fourth quarter of 2008.

June saw a trend toward higher yield and distressed securities outperforming those with better credit quality, as the new mix of convertible bond investors experienced an increase in risk appetite. Managers remain bullish on convertibles and believe they remain one of the cheaper asset classes in the capital structure.

In the event driven space, some managers gave back a portion of the profits they made in May, but believe that opportunities may develop as credit delinquencies continue to rise. Some event driven managers are adding exposure to risk arbitrage as they anticipate several deals that may close in 3Q-4Q.

Dispersion narrowed among the individual fund returns within each sector in June, with most having mixed performance. The exception on the positive side was convertible arbitrage, while dedicated short and managed futures had predominantly negative performance.

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