Jekyll and Hyde Markets Stalked February

RMF Investment Letter

Originally published in the April 2007 issue

The markets displayed a Jekyll and Hyde nature in February. In the first part of the month, the goldilocks scenario continued with a positive global growth outlook, modest inflation expectations and strong employment data fuelling the overall market sentiment. As a consequence, assets such as equities continued to perform well and market participants with net long exposures took advantage of upside momentum. In stark contrast, the second part of the month was characterised by a steep market sell off among risky assets that hit the market during the last week of February.

A sharp fall in Chinese equities occurred in conjunction with soft US growth data and ongoing worries about the US housing market. The resulting pain across most asset classes was broad based. Emerging markets and high-yielding currencies associated with the carry trade came under pressure, while the Yen had its strongest upward move since 2005. In the upheaval, the S&P 500 suffered its sharpest daily decline in percentage terms since March 2003 and the VIX had the largest one day spike since 1989.

The speed of the sell off in February was faster than it was during the May 2006 correction. On both occasions, derivatives trading was at exceptionally high levels. However, the volume surge in May occurred in the second week of the sell off, while in February it occurred on the first day. Only commodities escaped the turbulence, having already experienced a sell off in January.

Prices in this asset class now seem to be based largely on the assumption of a strong global economy going forward. This perspective is at odds with the equity markets, which typically lead the world economy by six months and suggest that the outlook may not be quite so rosy.

Hedge fund overview

The estimated return for RMF Four Seasons in February is approximately 0.27%. This gain was achieved despite a challenging environment in global capital markets during the month. It is pleasing that the overall portfolio held up well and kept money during this turbulence.

In contrast, the HFRX Global Hedge Fund Index finished down -0.21%. Four out of the five styles within RMF Four Seasons posted gains. Equity hedged funds recorded a gain of 0.30% despite acute market falls at the end of February. Many managers had adopted a more cautious stance and reduced exposure after taking some profits earlier in the month following strong stock market performance. Relative value added 1.03% as higher volatility provided a good environment for many strategies, particularly convertible bond managers and market neutral funds. The spike in volatility allowed managers to generate profits from existing trades and also created opportunities for funds to build new positions.

Event driven finished 1.04% higher despite the end of month instability. Most special situations funds did well. Deal flow remained strong and managers with a hedged exposure were sufficiently protected during the negative market action. Managers holding aggressive long positions suffered. There was little impact in credit markets and distressed managers posted gains. Global macro generated a gain of 0.88% with most gains coming from commodity traders. Managed futures lost 4.11%. Gains in equities had supported the portfolio during the month, so the sharp reversals in stock indices hurt the portfolio significantly.

Equity hedged

Given the turmoil experienced by global equity markets in the last two days of the month it is pleasing to see so many managers delivering positive performance. In contrast to the sell off in May 2006, managers were much quicker in cutting exposures this time. Most of the funds that ended February in positive territory did so as they were able to build up enough of a performance cushion in the first weeks of the month.

Favourable equity markets, particularly in Asia, had enabled managers to accumulate profits. Up to February 27th, global equity markets were approaching new multi-year highs. The MSCI World Index fell 1.23% in February, losing 3.5% over the last two trading days of the month. Among global markets, Asia held up the best, with several markets in the region finishing the month in positive territory in January. The US and Europe were hit more severely by the sell off and finished down over the course of the month. In this challenging environment, it is encouraging to note that our short seller also contributed positively to overall returns.

Relative value

In general, performance was slightly positive for most strategies, except for some fixed income managers who had a bearish bias within their portfolios. The last three days of the month changed everything in terms of monthly P&L. The spike in volatility assisted most managers, meaning that February ended on a positive note. Naturally, funds with long volatility trades in place did very well.

Among the best performing managers were those employing convertible bond and volatility arbitrage strategies. In particular, managers benefited from long gamma positioning and a general demand for products with longer dated options, such as convertible bonds. Multi strategy managers were enjoying a good month, mainly driven by equity or event driven strategies. As the markets turned, managers were able to cover losses in those strategies through the convertibles or volatility books.

Despite the reversal of spreads at the end of the month, credit arbitrage posted decent numbers, aided by the irrational behaviour of some market participants.

Event driven

February proved to be a good month for event driven managers despite the global hiccup during the last two days of the month.

Special situations funds posted mixed results depending on net exposure. The sell off onthe 27th caused pain for the funds with heavy net long exposure while funds with a more market neutral exposure were able to keep their gains. Deal flow was strong. The market saw the announcement of the largest LBO deal in history with a USD$45 billion bid for TXU from KKR. This trumped the USD$38 billion bid for Equity Office Properties from Blackstone in January.

Corporate activity levels remain high. The divestiture of Chrysler from DaimlerChrysler is a large potential deal while Sainsbury's is currently being circled by a number of LBO shops and trade buyers.

Most distressed funds performed reasonably well and did not seem unduly affected by the panic in markets. Their conservative positioning at the top of the capital structure as well as tighter hedges no doubt helped them.

Global macro

Contributions came from all three sub-strategies with commodity managers leading, followed by emerging markets and global traders. The impact of the sell off among managers was mixed.

Some long biased emerging markets funds held well up by shifting exposure quickly, while other funds that held on to positions and hesitated to take significant action suffered. At the macro level, the steep appreciation of the Yen, rising volatility and falling yields had positive effects given the long stance of discretionary managers.

The commodity market correction which occurred in January assisted the portfolio to some degree. Some of the excess liquidity had already been removed from these markets and they proved resilient in February. As a result, commodities were mostly driven by underlying fundamentals.

Concerns over current supply and future demand growth kept traditional energy commodities future curves in contango and front end prices strong, while tight inventories led to the continued rise in nickel markets.

Managed futures

After four months of strong performance, managed futures finally gave back some profits.

The magnitude of losses in February was fairly severe following an acute market reversal in stock indices. Considering that the trend in equities had lasted since August 2006, and was accompanied by the low volatility associated with a rising market, managers had grown large positions and stacked up excellent profits. The rapid sell off was accompanied by a massive one day spike in the VIX index which jumped 64%.

As a consequence, managers were forced to cut positions and take some losses. Prior to this point, equities had enabled managers to contain poor performance in other asset classes. The reversal during January and the beginning of February of long established trends in both fixed income and FX, was affecting many managers adversely. This was exacerbated by a breaking up trend in grains and metals.

On a positive note, short term traders were able to profit from trading around the volatility moves. However this was not enough to make back losses elsewhere. The confluence of these events plus sharp falls in equities late in the month meant managers posted large losses rather than a small profit.