RMF Quarterly Review

October 2006

Thomas Della Case and Mark Rechsteiner, RMF
Originally published in the November 2006 issue

The third quarter is often tricky for investors, as the summer months are usually marked by lower volumes and negative sentiment. However, Q3 this year was different. Coming out of a sharp pullback in May and June, nearly all equity indices recovered nicely and some even reach new heights.

The MSCI World Index gained 4.75% (YTD 6.42% in LC) in the quarter. A stronger than expected world economy, benign inflation numbers, buoyant M&A activity, weakening energy prices, and a pause in rate hikes by the Fed all contributed to the bullish mood. Bond markets, which trended downwards in H1, reversed and posted strong returns over the period. Citigroup’s World Government Bond Index gained 2.76% (YTD 0.61% in LC).

The strong fixed income markets surprised many as central banks are still rather hawkish and rates had been on a clear uptrend in Q1 and Q2. In Q3, long term bond yields declined across all G7 economies. Credit markets were quiet. Spreads on high yield securities widened marginally, but most companies are in excellent health, so the default risks remain very low.

Commodities were the only asset class to post a hefty loss. After a long uptrend, the sector corrected sharply. The energy sector was hardest hit, posting its largest loss in four years. In the first half of 2006, concerns over gasoline inventories, hurricane activity, and geopolitical tensions lifted commodity prices to record levels. During the third quarter, however, these worries seemed overdone and energy prices dropped vigorously. Additionally, hedge funds and other asset managers unwound speculative positions. Most commodity indices lost over 10% in Q3 and are flat to slightly negative for the year.

Hedge funds had a difficult quarter, with modest gains in July and August, but tougher trading conditions in September. The HFRX Global Hedge Fund Index gained 0.69% (YTD 3.82%) over Q3. Equity hedged and event driven hedge funds did well as equity markets rose and corporate activity, particularly M&A, remains strong. It was a tough environment for macro managers and CTAs, however, as fixed income, commodity, and currency markets proved difficult. Macro managers were hurt by the relative strength of the US dollar, particularly against the Asian currency basket, and CTAs were stopped out of their short bond positions. Sharp reversals in commodity prices, particularly in natural gas, hurt a number of funds. The market turbulence led to the failure of Amaranth, a large multi-strategy fund that had concentrated exposure to the natural gas market, which hurt sentiment and pushed prices lower in some sectors as the manager exited positions.

Large caps now favoured

Equity hedged benefited from rising share values across the globe as a less hawkish Fed and a growing conviction that the US economy will have a soft landing raised expectations for further profit growth. Easing geo-political tensions, falling energy prices and significant growth in corporate activity also drove equity markets higher. Europe once again performed slightly better than the other regions. Lagging sectors such as telecom and healthcare performed particularly well as takeover speculation intensified in September. Large caps are now favoured by many managers as small and mid caps seem fully valued after recent gains.

Event driven strategies also did well. We will cover special situations in ourspecial topic section. Distressed securities managers are still making money, thought much of the low hanging fruit has been picked. Credit markets were quiet over the quarter. High yields spreads widened marginally, but this was offset by declining government bond yields. Default rates remain at record low levels. Alternative risk transfer was positive as predictions of an active hurricane season proved unfounded and no significant events affected the portfolio.

“It seems like none of the big exchanges want to be left small and alone at the end of the game”

Commodity hedge funds lost money, hurt by sharp reversals in the energy complex. The sector performed positively until the beginning of August, when elevated inventory levels weighed on natural gas, crude oil, and gasoline prices. As a consequence, energy stocks significantly underperformed the broader market. This weakness in energy commodities and equities became more pronounced in September as reports of historically high inventory levels, a benign hurricane season, cooling geo-political tensions, and the unwinding of nearly 100 million barrels worth of futures contracts further depressed prices.

Natural gas and gasoline futures

In this environment, several large hedge funds experienced significant losses, leading to further selling in the market. Light sweet crude oil futures fell from a high of $79.45 per barrel on 14 July, to $59.65 on 25 September, a drop of -25%, before finishing the quarter at $62.91. Natural gas prices, which had already trended lower in H1, plummeted over 30%, and gasoline sold off 35%. Nearby natural gas future prices reached levels last seen in winter 2002, including an intraday low of $4.05 per million BTU. While hedge funds only control a tiny share of the $7trn global energy market, they do have concentrated positions in some parts of the markets, such as gasoline and natural gas futures.

Most energy hedge funds do not just take pure long or short positions, but adopt a view on the shape of the forward curve. In natural gas, for example, prices are considerably different in the summer, winter and the shoulder months due to changing demand patters.

Prices are usually much higher in the winter months as natural gas is used for heating. In the summer, demand can also be high when temperatures soar, increasing the load on gas fired power plants to meet the demand for air conditioning. The US enjoyed a mild winter this year and storage injection began far earlier than usual.

A heat wave in some parts of the US in late July resulted in record power demand and caused some extraordinary volatility in the natural gas market. Prices rallied as the fear of near-term oversupply faded. Managers generally benefited from this. However, August and September brought the bears out again as cooler summer weather with no hurricane activity led to record storage injection. The price difference is usually highest in the March to April months as March is the last month of winter when heating demand drops and storage injection begins. This spread is highly volatile. Amaranth, the failed hedge fund, was exposed to this spread trade.


The base metal sector was essentially flat this quarter. Copper futures oscillated between concerns about the rapid slowdown in the US housing market and an unusually protracted strike at Chile’s Escondida mine. The end of the four-week strike at Escondida was greeted by an unexpected rally in the futures markets.

Nickel futures soared due to a much publicised rally in short covering. The jump was primarily due to an open interest report showing a dominant short in the September 2006 contract. Nevertheless, demand from the stainless steel sector and a lengthy strike at Inco’s Voisey mine continued to support nickel prices. Precious metals had a difficult quarter as the sell-off in energy also dragged the gold sector lower. Junior gold equities were particularly affected. The Amex Gold Mines Index lost almost 8% during the quarter, with almost all of this loss occurring in the first two weeks of September.

In soft commodities, sugar was the dud and wheat the stud. Sugar futures were hit by heavy fund liquidation, concerns over the drop in crude prices could crimp ethanol-related sugar demand, and favourable growing conditions for Brazil’s crop.

The bounce back in corn came too late for managers who anticipated that stocks would be lower than the USDA had previously estimated. Wheat futures rallied at the end of the quarter (although most of the rally took place in early October). The world’s wheat stockpiles are at their lowest level in more than 25 years as Australia, a leading producer, is experiencing a severe drought that could cut its harvest in half.

Global traders produced mixed results. Several major themes such as short dollar, long Asian currencies and rising bond yields did not play out as expected. In the currency sector, the dollar showed unexpected strength when most macro traders had expected a weaker greenback after the Fed paused in August.

The end of Japanese zero interest rates

A majority of global traders expected a reflation in Japan and they were long Yen, short Japanese government bonds and long the Nikkei. However, the Yen weakened, JGBs strengthened and the Nikkei was flat. The end of the Bank of Japan’s zero interest rate policy did not have the expected impact and it soon became clear that inflation, and therefore rates, will stay very low for some time. In Europe, traders were wrong-footed by the Bank of England’s decision to raise rates. Fixed income markets performed strongly as bond yields fell. This was tricky for macro managers because the opposite had occurred in the previous two quarters. By contrast, carry trades delivered excellent results as high yielding currencies outperformed low yielding ones due to the weakness of the Yen.

Emerging market managers were up for the quarter. July and August were particularly good months as equity markets, EM bonds and currencies rallied strongly after the May/June sell-off. On the equity side, managers performed well in Asia and Latin America. India came back strongly with a double digit gain for the quarter (Q3 17.3%, YTD 30.96%).

Emerging Europe clearly underperformed as Russia, with its heavy energy exposure, sold off in September. Fixed income markets also performed strongly with EM spreads coming in by 13bps. Latin American bonds posted large gains as inflation in Mexico and Brazil dropped below US levels. EM currencies also strengthened a bit and local currency fixed income managers benefited from higher carry and stronger currencies such as the Mexican Peso and Turkish Lira.

Managed futures put in another unsatisfactory performance. While August was positive, July was deeply – and September slightly – negative.

The quarter started poorly as the sudden reversal in bonds hurt long-term trend followers. Bonds remained strong throughout the quarter and most long-term trend followers switched from short to long in August, recouping some of their earlier losses. Rising equity indices also helped.

September was volatile but ended flat after early losses in currencies were offset by short positions in energy and long equities later in the month. Short-term trend followers provided diversification to the highly correlated trend followers, but their performance was modest.

Relative value strategies made modest gains. The HFRX Relative Value Arbitrage Index gained 1.86% (YTD 5.62%). July was the strongest month as volatility-based strategies, such as convertible bond arbitrage, benefited from a decent realised volatility (gamma trading) and from richening in a number of names in the market. Equity market neutral also performed well in July as sector rotation benefited managers. August and September were difficult for nearly all relative value strategies. Long volatility trades suffered from price pressure, particularly in Asia, in shorter as well as longer term volatility.

Fixed incometraders also had to navigate some rough waters as more directional strategies, such as outright shorts, conditional steepeners or linkers in JGBs, posted significant losses. There were relatively few opportunities to make money, and these were mainly in the US market. September was another tricky month but fortunately the spill over effect from the liquidation of Amaranth assets, such as leveraged loans and convertibles, was minimal. Multi-strategy managers were mostly flat or slightly positive.

Special Topic: Special Situations

Special situations strategies are part of the event driven hedge fund style. They seek to generate returns from events that may effect valuations of a company’s securities. These events include mergers and acquisitions (M&A), spin-offs and carve-outs, reorganisation of the capital structure or operations and share buy-backs. While there are long-only funds and private investment firms that specialise in this area, it has long been preferred by hedge funds as sources of alpha are plentiful. It is estimated that about 14% of all hedge fund assets are allocated to the event driven style (ex distressed securities), most of which are in the special situations bucket. Managers tend to have concentrated portfolios of about 10-30 positions with the largest five positions typically accounting for about 30-40% of the book.

Special situations strategies have performed well over the last few quarters thanks to a high level of corporate activity. The current environment is still supportive as corporate activity in the US, Europe and Asia remains robust. While special situations managers aim to find interesting opportunities in both bull and bear markets, it is easier to generate returns in a bullish environment as the deal pipeline tends to be much larger. Additionally, many fund managers hold small and mid cap stocks that usually outperform large caps in a bull market. Obviously, this can be a disadvantage during corrections as witnessed in October 2005 and May 2006. Over the long term, significant alpha opportunities can be exploited as there will always be companies that go through restructurings, sell off underperforming assets, look for acquisitions, etc. Hedging techniques are applied on the position as well as at the sector and portfolio level using put options, CDS, index futures, or ETFs.

Events in bull and bear markets

Bull market events:

  • High M&A and leveraged buyout (LBO) activity
  • Share buybacks, dividend increases
  • Financial and operational restructuring

Bear market events

  • Liquidation
  • Financial restructuring
  • Rationalisation

Corporate activity slowed dramatically during the equity bear market of 2000 to 2002, as companies cut spending and focused on restructuring their balance sheets. The situation changed dramatically in 2005, with a surge in corporate activity, particularly M&A, and 2006 has been even more active still. By the end of September 2006, the global volume of M&A transactions had reached over $2.5trn, almost matching the total for all of 2005. This global phenomenon is largely due to low interest rates, low credit spreads, strong stock markets (where equity is used as a currency), a shift by companies from cost cutting to growth opportunities and a solid macro economic environment. Record fundraising from LBO firms has led to an increasing number of hostile and competitive bids. Japan has also seen an increase in opportunities as proposed changes in legislation are set to encourage cross-border M&A.

Managers generally monitor the markets and search for companies that are about to undergo changes or where specific changes have already been announced. The classical example is to play the merger spread. This is a fairly straightforward trade as the manager goes long the target company’s stock and short the equivalent amount of the bidder’s stock after the bid is announced. Typically, the target company’s stock does not fully trade up to the bidding price as there is always the risk of the deal failing. However, if the transaction goes through, the manager pockets the difference. Managers fine tune their positions depending on the terms of the bid (e.g. is it friendly or hostile, cash for stock, stock for stock, a combination of cash and stock, etc). In the past, merger arbitrage has been a reasonably profitable technique enjoyed by hedge fund and investment banks’ proprietary traders. Today, however, the returns from this strategy have declined. This is due to two main factors. Firstly, there are more arbitrage players competing for potential profits as hedge fund and prop desk assets have increased substantially over the last few years. Secondly, the number of hostile bids, where spreads are larger, has declined (even through it has been on the rise recently). Additionally, companies now bid more cautiously, unwilling to make large bids that could seriously impact their balance sheets. Hence, this strategy now only comprises a small portion of the special situations universe.

These days managers generally make directional calls on stocks and sectors they think will benefit from fundamental value created in rumoured and announced deals. As we will describe in more detail, such calls have recently been made on the Italian banking sector, mid-tier mining stocks, financial exchanges and European cross-border deals. Some managers also adopt relative value strategies with less correlation to equity markets. These strategies include stub trades, holding company, dual listing and share class arbitrage. For the purpose of this review we will focus on equity based strategies and highlight the main themes that managers have played recently.

Understanding the private equity mindset

The key to a successful event driven fund is to understand the private equity and LBO mindset. Private equity firms have been involved in almost 20% of this years’ M&A deals, up from about 12% in 2004 and 2005. There were $300bn worth of buy-outs in H1 2006, almost matching the amount of the whole of 2005. Nine of the 10 biggest buy-outs ever occurred in 2005 and 2006.

A trend has emerged over the last year and a half for big private equity firms to collaborate on deals. Six large buy-out firms – KKR, Blackstone, Bain Capital, Carlyle, Texas Pacific Group and Permira – have worked together on a number of deals in excess of $10bn in the past 18 months, collectively worth more than $120bn. Several factors are behind the trend towards ‘clubbing’. First, the sheer amount of money pouring into private equity means big firms are looking for places to spend it, yet many have caps on how much they can invest in a single deal. Joining forces allows them to share costs and risk, and gives them the scope to take on far larger prey, allowing them to access a market segment that is out of reach of smaller players. Yet such groups also face challenges such as potential disagreements over price, management decisions, and exit strategies. Furthermore, the US Department of Justice has launched an informal inquiry into possibly anti-competitive behaviour among bidders.

Another recent trend is for private equity firms to target companies with low cash flows and collateral in sectors such as technology. Generally, target companies have been cash cows in mature industries (e.g. fast food, telecom, car rental) generating high free cash flows that could be

“The third quarter is often tricky for investors, with summer months usually marked by lower volumes and negative sentiment”

used to service debt. The buyer then had to restructure the business and cut costs to increase the profitability of the firm. However, these days, with only a limited number of such companies left, private equity firms have to venture into uncharted territory and target companies with lower cash flows and weaker balance sheets. Together with increasing levels of leverage, this may become an issue if the economy turns or interest rates rise sharply.

Consolidation in industries such as mining, financial exchanges, banks, and utilities has been a key theme over the last few quarters. With the exception of mining, most activity has been in Europe. While there has been a significant cross-continent consolidation in the US, Europe has only just started this process. Many industries such as telecoms, banks, and energy are still highly fragmented with a strong domestic bias to the respective national state.

The EU has made it clear that it aims to achieve a single European market and actively encourage cross-border transactions, but this has yet to happen. The introduction of the Euro, the absence of duties or quotas, and the harmonisation of laws and business practices has made cross-border integration easier. Nevertheless, national governments have used questionable practices such as golden shares to resist this process.

A golden share is a nominal share which is able to outvote all other shares in certain specified circumstances. This share is often held by a government organisation, in a former state-owned company undergoing the process of privatisation and transformation into a public company. In 2003 the UK government’s golden share in BAA, the UK airports authority, was ruled illegal by the European Court of Justice. It was deemed contradictory to the principle of free circulation of capital within the EU. European courts have already ruled against France, Portugal, the UK and Spain in similar cases. When EON bid for Endesa, Spain’s biggest electricity firm, earlier this year, the Spanish government tried to use its golden share to block the deal for ‘national security’ reasons, but was barred from doing so by the EU Commission. The Italian bank folly in 2005 made the headlines as the then governor of the Italian central bank, Antonio Fazio, tried to block ABN Amro’s bid for Banca Antonveneta using questionable practices. Despite these difficulties, European consolidation is picking up steam and more cross-border transactions can be expected.

An optimistic interpretation is that all this fuss is, in fact, a sign of the success of European corporate restructuring. A European merger wave has been gathering momentum since last year, when firms came out of a period of tough restructuring. Now most firms have a healthy balance sheet and are looking for new internal and external growth markets.

Utilities on fire

The Spanish utility sector has been very profitable for special situations funds in 2006. Regulatory decisions and M&A expectations have been the two chief drivers of this rally. Spanish tariffs have been capped since 1998 and are now €24 per MWh below the EU average. Liberalisation of depressed tariffs could imply a 30% jump in electricity bills and therefore much higher revenues and earnings. Utility experts estimate that the government will try to prevent a shock and prepare the domestic market for liberalisation by approving annual average increases of about 5% during 2007-2010. Beyond that date, tariffs should reflect the real cost of electricity. The expectation that upcoming regulatory changes will lead towards the gradual liberalisation of Spanish utilities over the next few years has attracted interest from hedge funds as well as Europe’s largest utility, EON, which bid for Endesa in February 2006.

EON’s cash offer was bigger and better than an earlier cash-and-shares offers by Gas Natural, another Spanish utility. The Spanish government deemed the German bid unwelcome and backed Gas Natural’s offer, despite its rejection by Spanish antitrust authorities, in the hope of creating a national energy champion. In late July, Spain’s energy regulator, which is controlled by a board close to the government, imposed 19 conditions on EON’s bid for Endesa, some of which are clearly bullying. For example, EON would have to sell all of Endesa’s coal-powered plants, because Spanish coal is subsidised and the government is worried the Germans would use cheaper imports.

The takeover fever intensified in September as Spanish construction and service group Acciona acquired 10% of Endesa (as of mid-October the holding is up to 20%) and ACS, another Spanish construction group, acquired 10% of Iberdrola, the second largest electricity producer behind Endesa. It is yet unclear if these engagements are purely financial or strategic. In any case, the prices paid were significantly higher than those previously paid prices on the exchange. EON was forced to increase its bid for Endesa by 40%, raising questions as to whether the deal still makes sense. Special situations managers have been able to benefit from rising share values in all Spanish utility stocks throughout 2006.

Mid-tier mining stocks: another boon for managers

Mid-tier mining stocks have been another lucrative area for managers. In May, prices for copper, nickel, and other metals rose to record levels, although they have since fallen a bit. In June, Phelps Dodge, a large US copper producer, announced it wants to take over two mid-sized Canadian miners, Inco and Falconbridge to create the world’s biggest producer of nickel, the number two in copper, and the fifth-ranked mining firm overall. Two other mining firms, Xstrata and Teck Cominco, had previously bid for Falconbridge and Inco respectively. Xstrata won the fight for Falconbridge but Inco went to Brazil’s CVRD, which is now the fourth largest mining group worldwide.

Soaring commodity prices have left mining firms flush with cash and keen to expand. As the development of new mines takes several years and some equipment and specialised staff cannot be obtained quickly, the big mining firms find it easier to grow their business through acquisitions. Some argue that shares are still attractively valued as they have lagged underlying commodity prices. Others think that large savings can be squeezed out of combined entities as equipment and personnel among adjacent mines can be shared. More importantly, they argue that the size and diversity of the new company will make it less vulnerable to mining’s painful cycles, and so more attractive to investors. The biggest and most diversified mining companies, such as BHP Billiton and Rio Tinto, do boast higher share valuation. By the same logic, the more mines a firm is running or developing, and the more countries it operates in, the less risk each individual mining project poses to profits. Metal mining stocks have performed excellently in 2006, and special situations managers were able to exploit this.

Some managers think that the consolidation in the mining industry will continue in the small and mid cap space. The recently announced merger between two mid-sized zinc producers, Eurozinc and Lundin Mining, could be the start of this.

“The EU has made it clear that it aims to achieve a single European market, but this has yet to happen.”

The battle of the bourses

The battle of the bourses has kept fund managers busy for over a year. Ever since last year’s failed takeover of the London Stock Exchange by Deutsche Boerse, there have been numerous bids and counter-bids among the world’s leading financial exchanges. Until April of this year, consolidation in Europe was expected to create two or three dominant stock exchanges. This paradigm was challenged when NASDAQ bought a stake in LSE. Shortly afterwards, the New York Stock Exchange placed a friendly bid for Euronext, its pan-European counterpart. Euronext had previously rejected a bid from Deutsche Boerse. It seems like none of the big exchanges wants to be left small and alone at the end of the game.

What is behind all this fuss? First, size matters in financial markets. After all, exchanges make their money by taking a small cut on shares that are bought and sold. The more volume they do, the finer the margin they can offer and the more business they can attract. More business means more liquidity and liquidity attracts traders. Secondly, a transatlantic merger, e.g. between NYSE and Euronext, would allow for synchronised all-hours global trading. This would constitute a perfect playground for hedge funds and prop desks that could trade around the clock. Additionally, American exchanges want more exposure in Europe as Chinese, Indian and Russian companies are keener to list in Europe and circumvent the burdensome Sarbanes-Oxley legislation. The boss of the NYSE, John Thain, has recently complained that America is losing out on IPOs because of excessive legislation.

So if everybody benefits, why has it not happened already? Share valuations have risen fast and at these levels any deal is expensive. Another worry is that Deutsche Boerse operates a vertically integrated trading ‘silo’ that makes it hard to identify the costs of trading, clearing and settlement. There were concerns that there is a hidden cross-subsidy between different parts of the business that may distort competition.

A European directive on clearing and settlement is likely to address this worry, but not for at least three years. In contrast, American exchanges are not responsible for clearing and settlement, which is one reason why the French government appears to favour the NYSE bid for Euronext.

Politics also play a role as both Paris and Frankfurt want to preserve a strong share trading operation. It remains to be seen how the exchange landscape will look after consolidation. Special situations funds have benefited from rising share prices across the board and have now partly realised profits.

In summary, the return drivers for special situations managers are: the level of corporate activity, sector and stock selection, exposure levels, market timing, the performance of equity markets and small and mid cap performance. Stock selection plays a higher role than in other hedge fund styles because portfolios are more concentrated, with the top five positions often comprising 30-40% of the total portfolio. A fund of special situations managers is designed to perform in both bull and bear markets.

However, corporate activity is higher during bull markets and is positively correlated to equity markets. Managers have been active in several main themes such as the Italian banking sector, mid-tier mining stocks, financial exchanges and European cross-border deals. Trading strategies vary from pure merger arbitrage of announced deals, to anticipation of future deals, as well as playing an active role in industry consolidation. LBO firms are likely to look at even bigger deals as they have record sums to invest. HCA, a US healthcare group, was taken over in July by private equity firms for $33bn. This was the largest such deal in history. A healthy number of deals can be expected over the next few months which will allow specialised managers to generate above average returns.