CMA's Senior Analysts draw some conclusions from 2006 and look forward to 2007 in relation to Equity, Arbitrage and Trading/Macro hedge fund strategies.

Equity

Risk reduction and a spike in volatility were felt in equity markets during the last week of February, as most long-biased managers lost a significant share of the profits gained during the month, also impacting returns from the previous 12 months. Prior to the recent correction, complacency was high and was evident in equity hedge fund net exposures, which hovered near 60-70%.

We can however draw some conclusions from 2006 and recent market events that will drive manager selection in our equity portfolios for the remainder of 2007. We have been concerned for some time about the large overlap of positions among both equity and event-driven funds. CMA has therefore focused on reducing the average market capitalisation of the core names in our managers' portfolios and has sought more specialised sector exposure. We have also continued to focus on net exposures, and have preferred managers that operate within a controlled range, both on a dollar and beta-adjusted basis. These managers have shown more resilience during difficult months and we feel that they will be better positioned to protect capital in case of any further weakness in global markets.

All this said, broadly speaking, liquidity and corporate activity remain high and industry-specific fundamentals are not uniformly weaker. However, the recent weakness in the subprime sector and its effect on the banking and real estate sectors should not be underestimated. Most experts do not see any contagion effect from one asset-backed segment of the market to other areas, but we believe it is too early to tell. Once defaults begin to rise, and spread to other sectors, the story could take a much more negative turn.

Arbitrage

* CONVERTIBLE ARBITRAGEAfter coming off a difficult 2005 into a good 2006 and looking to raise capital, most managers seem to be optimistic about the convertible bond market for 2007, being positive about the new issuance calendar and the potential for rising volatility.

A number of the managers we closely follow expect 2007 to look similar to 2006; and believe their performance will follow suit. We, however, are less optimistic. Although there are a number of positive catalysts that could help drive performance during the year, the biggest catalyst of 2006 – new money looking to get back into the strategy – will have less of an impact. We also feel there will be a greater divergence in returns among competing funds, and portfolio management will help distinguish the more elite managers, which was not necessarily the case in 2006. Furthermore, credit exposure has benefited the sector, but may arguably be more difficult going forward. We tend to focus on funds that more actively hedge credit exposure.
 

* CREDITMost of the managers we research cannot identify a catalyst for credit spreads to widen, but note that a significant amount of leverage is beginning to accumulate in certain names/sectors. This leverage is related to takeover activity, but also includes portfolio leverage among hedge funds with credit exposure. Managers are unclear about the catalyst for the credit market to finally crack, although many believe that when it does, the impact will be severe. Some managers believe this crash will be relatively short, followed by a bounce. Others believe that weakness in credit markets will quickly spread to other sectors, and will therefore last longer. We remain cautious, and prefer relative value trades.

* FIXED INCOMEManagers in this strategy cannot point to an immediate catalyst that may drive bond volatility higher in 2007. They instead note that volatility cannot remain at the presently low levels forever. We remain cautious about return characteristics for fixed income arbitrage managers. This is because results, if any volatility catalyst were to materialise, will be a function of individual positioning and leverage. Once volatilities are higher, the opportunity set should indeed be improved, but the inflection point itself is not necessarily a positive.

* CARRY & INCOMEThe trend in 2007 appears to be similar to the prevailing trend throughout the second half of 2006, with weakness in the sub-prime sector and strength in the commercial mortgage space. Many managers seem to believe that current trends will continue, and have profited from portfolio hedges in the subprime market. Our research will thus focus on building a diverse portfolio of different collateral types with an effort to produce high annualised returns and low volatility.

The subprime sector has been hit pretty hard over the past few months, most notably in February, but had a small rebound in the first week of March. However, this rebound is attributed mostly to short covering and reassuring comments made by the Fed. The general view by many mortgage investors is that the weakness in the subprime sector will continue over a period of 6-12 months.

However, there seems to be a fairly large dispersion of opinion as to how bad things will get. A number of funds, and a variety of groups who have not traditionally been involved in this sector, have been very active in trying to find ways to 'arbitrage' the subprime market. Some are doing so by simply shorting the ABX Index (which represents a basket of credit default swaps on high risk mortgages and home equity loans) and others are taking a more relative-value approach, believing that many of the securities in this sector of the market are being marked down without justification.

It should be noted that the basis between the ABX and the cash market has increased significantly during this volatile period. Some have also begun to question the prime mortgage market; a sector of the mortgage market that until recently has performed well; weakness in this sector could have much more of an impact on the US economy.

The MLP (Master Limited Partnership) sector has held up well during this period of distress in the global financial markets. The story in the MLP sector continues to be very good; buoyed by strong fundamental factors, continued distribution increases and increasing institutional interest. The REIT (Real Estate Investment Trust) sector has however been under pressure over the past few weeks. The weakness is this market actually pre-dated the February 27th, market collapse.

The PIPE (Private Investment in Public Equity) sector has started the year on a strong note. In February alone, the market raised almost $7.5 billion (187 deals according to PrivateRaise), three times the capital it raised in February 2006. Investors did more deals, and the average deal has more than doubled in size. The average deal size in February was about $40 million, compared to $15.7 million during the same period in 2006.

It isn't clear if strong issuance in February reflects a trend for the remainder of the year, but the market has been growing dramatically over the last 12-18 months. PIPE funds seems to be largely unaffected by the recent market declines, and generally had a fairly solid month.

Trading/macro

Consensus had generally been building for only a moderate slowdown in the global economy for 2007, which generally translates to a bullish view for equities and emerging markets, and a bearish view for bonds. We have in fact noticed at least some instances, where funds that had been bearish coming into 2006, have capitulated on the view and were markedly more bullish going into 2007.

The view, as it applies to the US, is that improving employment and personal income figures should support the consumer. One may also add that equity valuations are not necessarily stretched.

Corporate profitability remains strong, even if margins may have peaked. So, positioning remains long equities, long emerging markets. The emerging markets view is likely least changed, with funds pointing to solid fundamentals and a current account surplus for a number of countries. Within emerging markets, the focus remains on Brazil, Mexico, Turkey, and a number of countries in Asia.

At this point one may note that consensus was generally wrong in 2006, and that the worst thing about consensus is that if the view does not materialise as expected, all market participants run for the door simultaneously. February could be another example of a turn against consensus.

However, macro results were generally good, albeit mixed, for 2007 to-date. While the above thesis seems to remain intact among managers, many of our holdings traded well during recent weeks. In fact, some were very timely with short equity index positions, and others had already taken some profits following a strong fourth quarter run.

Strategy conclusions for 2007

CMA will focus on several key themes for 2007 to ensure that we continue to meet our investors' expectations.

As noted in the Equity section above, we feel that equity strategies have in general become more correlated and directional throughout the past year. Our effort in 2007 will be to migrate this beta away from generalist exposure into sector-specific strategies. We believe this will allow us to better control the overall beta of CMA portfolios by introducing greater differentiation among our equity funds. We have also altered our exposure in some of our other strategy classifications. Within the macro space, our approach into 2007 has centred on relative-value strategies that focus on fixed income and currency markets, and may benefit from rising bond yield volatility. We continue to complement such exposure with classic directional macro strategies, but take a more targeted approach.

Within Arbitrage, we have added to volatility-based strategies. These are long volatility strategies that will shield some of our portfolio beta. We feel the addition of such exposure will further improve the overall return characteristics of CMA portfolios. Also, volatility may be attractive in absolute terms after several years of declining volatility across asset classes.