The year started well for most asset classes as equity and commodity markets rallied on the back of continued economic growth, a steady flow of positive corporate news and extensive money flows into emerging markets and commodities. In the first four months of the year, high beta sectors performed especially well with small caps and emerging markets taking the lead. Commodities also rose strongly on the back of strong fund flows and reports of dwindling inventories with metals, both base and precious, making the strongest gains. Bond markets, however, suffered in Ql as rising short-term interest rates began to impact on the long end of the yield-curve in the US and Europe. Long-term bond yields in both regions rose in almost perfect synchrony by about 80 basis points, putting pressure on bond markets.

As a result, hedge funds had their best quarter in two and a half years in Ql with all styles contributing positively. Directional strategies outperformed arbitrageurs as rising equity and commodity prices and falling fixed income markets provided fertile grounds for profits. Top performers were funds with exposure to the metals complex and emerging markets.

The party came to an abrupt end in the second week of May when concerns over US interest rates triggered a massive sell-off. Leading indicators pointed to an economic slowdown but CPI data moved higher, raising qualms that the Fed may overreact and commit a 'policy mistake', raising interest rates too aggressively because of near-term CPI data. The much feared stagflation scenario spooked investors across all asset classes. The correction was felt most strongly in markets which had made the largest gains, such as the metals complex. Equity markets fell into negative territory for the year in June.

Interestingly, in contrast to the April 2005 correction, where investors fled to quality (government bonds) and away from credit, this time it was more of a flight to cash.

Unfortunately, hedge funds could not provide much protection in the face of such a concerted sell-off, and all styles posted losses. While most managers had anticipated a correction, the timing and magnitude caught them off guard. Additionally, liquidity dried up in some areas, including several emerging markets, as everybody tried to exit at the same time. Most hedge funds reduced their leverage and exposure levels quickly and were able to minimise losses in the second wave of the sell-off in June. Relative value managers held up fairly well given the speed with which investor sentiment changed.

In particular, long volatility strategies benefited from the market turbulence to post good gains. However, these strategies were not able to offset the large declines in the other styles. The performance of gold, typically a safe haven during market corrections, points out just how widespread the rout was. As Fig.l shows, it sold off at exactly the same time as other assets.

Markets paused briefly after the sharp correction and then most began to rise. This swing from extreme pessimism to moderate optimism baffled many seasoned investors who watched developments from the sidelines. Equity markets climbed steadily despite growing signs of a US economic slowdown, the war in Lebanon and attempted terror attacks in the UK. The rise was helped by falling oil prices, retreating long-term bond yields and growing confidence that the Fed had finished raising rates for the time being.

Many hedge funds failed to capitalise on this recovery as they had significantly reduced their exposure and leverage during and after the May/ |une correction to protect against further losses. Additionally, several themes did not play out as anticipated. Global macro traders, for example, were hurt by the relative strength of the US dollar and weakness of the Asian currency baskets. Many macro managers were short the USD versus Asian currencies, in particular the Yen, in anticipation of more aggressive tightening by the Bank of Japan, which has not yet materialised. CTAs were stopped out of their short bond positions as the global fixed income market completely reversed in July.

Global equity markets gained momentum in September and October as the Oj earnings season and companies' guidance for 2007 largely beat expectations. The world economy continues to expand strongly despite the slowdown in the US, which seems to be concentrated in housing and automobile manufacturing. Investors and hedge funds that were cautions going into what is traditionally a difficult period soon found themselves lagging the major indices and increased their exposure levels once more. By October, most funds were fully positioned again and all styles benefited from strong directional moves across multiple asset classes. A surge in M & A activity boosted event driven funds as several companies, particularly mining firms and the financial exchanges, received multiple bids from rivals.

Private equity firms accelerated their activities and several large deals were announced which helped special situations managers generate excellent returns. Managed futures were also back on the winning side as the uptrend in equities and fixed income continued.

On the other hand, 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 markets. While the total losses were substantial, it remained an isolated event and did not trigger a chain reaction. The situation was helped by the positive market conditions and the swift transfer of large parts of the portfolio to other managers.

An important factor constraining hedge fund returns in 2006 has been historically low levels of volatility across almost all asset classes. The Goldman Sachs Volatility Index (Fig.3), which measures implied volatility across a number of asset classes, is currently at a 27-year low. Nearly all asset classes price in little risk going forward. This lack of volatility could be seen as an indication that investors are complacent and expect stability and ample liquidity to continue.

Worries about global economic imbalances, such as the US trade deficit, have taken a back seat and are not priced in at the moment despite the fact that they continue to grow. The VIX Index, which measures short-term implied volatility of the S & P 500, is currently around 10%. In the past, such low levels were followed by strong sell-offs. For example, in August 1998 (LTCM/Russian debt default) or February 1994 (Fed hikes rates unexpectedly). As a result, volatility traders with a long bias and more cautious managers that were negative on credit, bonds or the US dollar had a hard time this year. However, we believe that it is worth including them in a diversified portfolio as they represent a relatively cost effective hedge against other strategies, such as emerging markets and commodities, which do better in a bullish environment.

In summary, hedge funds faced nearly perfect trading conditions from |anuary through April, but incurred losses in May and |une as a range of asset classes corrected sharply. This led to a general risk reduction as funds focused on preserving capital. As a result, few managers benefited fully from the remarkably quick rebound, but most funds were back on track by late autumn and performed well in October and November. Depending on how December turns out, 2006 is likely to be a year in line with expectations, similar to 2005.

Outlook 2007
The world economy is expected to slow moderately in 2007, primarily due to a soft patch in the US. Earnings are set to show only moderate growth. This appears to be priced into the markets already as they did not react adversely when companies lowered their guidance for next year.

A moderate slowdown in profit growth can be seen as favourable as it prevents the economy from overheating and reins in investor confidence. Equity market valuations do not look stretched and the asset class looks relatively attractive when compared to bonds. Taking a 10-year valuation average for the US and European equity markets – excluding the 2000 multiples – the markets would still have some 10% upside based on current ratios. Emerging markets, particularly in Asia, also offer good opportunities. In |apan, small and mid cap stock have corrected heavily in 2006 and now offer opportunities again. Strong swings in money flows, however, could put a lid on performance and equity markets thus require a cautious approach. As a result, we see potential for further gains by equities but with increasing downside risk. Thus, the outlook for equity hedged strategies remains favourable. Bond markets currently price in a more pronounced downturn as long-termyields in the US remain stubbornly below short-term yields. Fixed income arbitrageurs will struggle to identify fresh opportunities in this environment. We expect better performance from convertible bond arbitrageurs as volatility is the cheapest asset class. We think that convertible bond arbitrage is a smart way to gain exposure to cheap implied volatility with the option to make money and pay premiums by actively trading the gamma.

Hedge funds generally prefer high volatility and strong directional moves so the current low volatility environment is a constraint on most strategies. In particular arbitrage strategies are set to remain challenging as long as volatility is low. For example credit arbitrage has been restricted by the lack of movement in credit spreads, which remain about as tight as it gets. However, this can change quickly and idiosyncratic credit dislocations caused by corporate events, such as M & A and LBO situations, are expected to create attractive opportunities.

Record low default rates make it difficult for classic distressed securities players to generate above average returns. Supply has been insufficient for some time due to the fundamentally sound economic environment, which has been particularly tough for passive funds. We think that the active funds will fare better and continue to outperform the passive managers. However, in event driven, we prefer special situations over distressed securities.

Corporate deal flow remains very high with M & A activity continuing at a strong pace on both sides of the Atlantic. In recent months, the merger wave even intensified. In just one day, 20 November 2006, 35 transactions worth USD 75 billion were announced globally. This reflects strong corporate balance sheets as many firms have focused on cutting costs and reducing debt over the past few years and are now looking outward to boost growth. Special situation managers should continue to find ample opportunities as corporate cash levels are still high and private equity firms, which globally collected USD 172 billion YTD, still seek appropriate targets.

The environment for global traders has been challenging this year as contradicting information about the state of key economies sent yields higher in Ql and lower in Q2 (see Fig.7). Now, it seems that the Fed has switched to a wait and see stance and it remains unclear if the next move will be up or down from the current 5.25% federal funds rate. In October and November, bond market sentiment switched several times. A more bullish outlook on the economy sent long-term bond yields and the US dollar higher, and vice versa. We believe that global traders will perform better in 2007 as the US dollar and yields could move quickly when a clearer picture develops. Global traders are discretionary and therefore able to move quickly. One scenario that would be beneficial for macro traders is a rapidly weakening US economy that would prompt the Fed to rapidly lower interest rates, which could be followed by a sharp USD sell-off. Other themes, such as the appreciation of Asian currencies, could also play out nicely. Classic carry trades have also made a comeback as high yielding currencies have outperformed low yielding ones in recent months.

It will be interesting to watch how the new US Congress deals with issues such as protectionism. Over the past two years, there have been several initiatives by members of Congress to levy import duties on Chinese goods and to bully the Chinese to revalue the Yuan. The most prominent such initiative has been the Schumer/Graham bill which aims to levy a 27.5% punitive tariff duty on Chinese goods unless the country revalues the Yuan significantly. Both Schumer and Graham are Democrats, which now have a majority in both chambers. As always, protectionism has political appeal and little economic cost in the short run. However, in the longer term itincreases inflation and reduces productivity. Currently, there seems to be little to fear as Republicans could filibuster and President Bush veto such a bill. Nonetheless, macro traders will be keeping a careful eye on any developments. If Sino-American relations turn sour, this could be a stumbling block for the US as the Bank of China now holds over USD 1 trillion. If it only sold a small portion of this stack, it would certainly send waves through financial markets.

Emerging market managers had a hard time in 2006 as sentiment changed several times. Currently, investors seem optimistic and indices have fully recovered from the May/|une carnage. The much feared [eft wing factions in South America were kept at bay as extremists failed to win key elections. Looking ahead, emerging markets remain attractive but also vulnerable to external money flows. As many of the funds active in this area are long/ short equity managers with limited opportunities to hedge their positions, we see better downside protection in global traders.

The investment case for commodities remains intact going into 2007. Some heat has come out of the sector as many speculative positions have been unwound, particularly in energy. We expect the consolidation to continue for some time. As the US economy slows some inventories, such as copper, are rising. Oil and gas inventories are higher than average. Some disappointed investors are pulling out money, in particular funds tied to commodity indices that have suffered from negative roll yields in 2006. Nonetheless the long term fundamentals remain in place as emerging Asian economies will need more raw materials to industrialise. This, coupled with supply threatening geo-political uncertainties in the Middle East, will keep the pressure on energy prices. Thus, while the short term picture looks somewhat mixed, the commodities bull is far from dead.

Managed futures were hit by a number of sharp reversals, particularly during the second quarter. The strengthening of the US dollar, which started in May, the correction in the energy complex and the reversal in bond yields had a detrimental impact on systematic trend followers. Currently, there are few clear trends in bonds, currencies or commodities and thus the outlook for managed futures remains muted. However, we view the current lack of profit opportunities as a temporary situation. Sooner or later trends will re-emerge and volatility will rise again across multiple asset classes. Possible triggers could be the US housing market, a more severe economic slowdown, an unexpected rise in core inflation, or a crisis in the financial system. Historically, managed futures returns have been cyclical. Periods of low returns are normally followed by periods of higher returns. We remain confident about the long term return potential of CTAs but remain neutral until we see a clearer picture.

We expect a challenging environment for hedge funds in 2007. The low volatility across multiple asset classes makes it difficult to find ample profit opportunities. Compared to 2006 we see the most improvements in convertible bond arbitrage and global trading. Volatility has, historically, been cyclical and it is likely that higher volatility will return at some point next year. Hence, we believe that volatility based strategies represent a favourable risk/return trade off as volatility is the only asset class priced at multi-year lows. We aim to make money in most market conditions, but would clearly benefit from profound dislocations or strong trends in currencies, equities, fixed income and commodities.

The big challenge for hedge funds in 2007 will be increased pressure on performance from high interest rates, and we expect to see some rationalisation and consolidation in the industry, particularly affecting managers who fail to meet client expectations. Consolidation in the sector seems likely, and the number of fund of hedge funds providers will certainly decrease over the foreseeable future.