In 2006, hedge funds performed in line with the expectations that we set at the end of 2005. At that point in time we expected hedge funds to deliver mid to high single-digit returns while maintaining a modest volatility profile. For the year, the HFRX Global Hedge Fund Index gained 9.25%. Despite the fact that investing is a continual process, one that requires ongoing research, assessments of changing markets and the development of forward looking opinions, we are continually asked how will hedge funds perform in the new year?

The process of compartmentalising time periods is a reality of how people like to think. Therefore, as the year gets underway we are once again asked to provide our views. For 2007, we see a modest increase in returns versus the high single-digit performance of 2006. Based on our current expectations, we believe it is reasonable to expect hedge funds to return on average 10% to 11% net of fees.

Historically the first and fourth quarters have been kinder to hedge fund managers than the second and third, and 2006 was no exception to this pattern of performance. In fact the fourth quarter really made the year for many managers. At the end of the third quarter, the Hedge Fund Research Global Hedge Fund Index was up 3.82% and all of that was earned in the first quarter. In the fourth quarter the index jumped by nearly 5.25% and the pattern held.

As we move into the first quarter, market conditions and the positioning of portfolios by hedge fund managers appear to be in alignment, and given the momentum it’s reasonable to expect to see solid performance in first quarter.

Citigroup Alternative Investments’ external hedge fund business breaks the hedge fund universe down into four categories; directional macro, directional equity, relative value arbitrage and event-driven with each of these categories divided into a number of specific sub-strategies.

Directional macro: cautiously optimistic

Over the next several quarters, CAI is neutral on the directional macro sector. The opportunity set for macro managers is and should remain attractive. However, the trading environment that currently exists has made it difficult for many macro managers to capitalise on the opportunity set. We currently favour short-term higher frequency traders and traders that utilise both technical and fundamentals factors in their decision process. Additionally, greater weight should be placed on managers that utilise a discretionary component in their trading approach. Despite the change in policy by the Bank of Japan, interest rates in that country remain low and are expected to remain low relative to the returns available in the rest of the world: as such borrowing in Yen and investing in other higher yielding investments is expected to continue. The Yen carry trade as it is known, should be watched closely, as any acceleration in the unwinding of this trade will have a negative impact on a number of strategies. This trade is not only related to macro managers but can also have an impact on a number of other hedge fund sectors. Remember, just a hint of this trade unwinding contributed to the sell off of last May and June. Should this trade really unwind, the markets will be in for some very difficult times.

Directional equity: the one to watch

The directional equity strategy continues to be viewed positively. Based on our current expectations this should be one of the better performing hedge fund sectors in 2007. In part, our positive outlook for the sector is a function of our continued expectations for positive global equity markets. However, while constructive on equities for the year, we do anticipate a modest pull back in the near term, most likely sometime toward the end of the first or during the second quarter. Also supporting the outlook are the demographics of the equity markets. The combination of corporate share repurchase plans, ongoing private equity activity and companies going private, (especially in the small and micro cap space which also happens to be favoured by many hedge fund managers) all tend to reduce the supply of available stock. At the same time, the demand for investments continues to grow. This demand has been supported by the amount of capital that has been created over the past few years, the high level of liquidity in the markets and the growth of the global economy. These conditions clearly support the beta component that exists in the portfolios of managers in this space. Concerns do exist however and should be kept in mind. One such concern for US equities is that US companies have benefited from four years of quarter-on-quarter earnings growth. Can it continue? Perhaps, but at some point it will stop and the market will come under pressure. In addition there does appear to be a little too much complacency about the continuation of the ‘goldilocks’ stock market.

Within the long/short strategy, emerging market focused managers are expected to continue to perform well. The emerging markets have grown up and are in much better financial shape than in the past. In addition, emerging markets have developed more established and robust local economies and are beginning to see internal demand for investments. As the BRIC and the other EM countries build a middle class and incomes increase, their populations will begin to invest and will support their own markets. But note that despite what some see as a new paradigm for emerging markets this sub-sector will continue to be subject to significant sell offs; witness May 2006. This should not discourage investors from investing in EM focused hedge funds; it simply requires identifying the right managers and sizing them appropriately.

It is worth keeping in mind that one does not or at least should not buy long/short equity hedge funds just for a beta trade; after all there are cheaper ways to get beta exposure. We believe the current environment favours good stock selection; the market will differentiate between good and bad companies and long/short managers are in the business to capture these opportunities. We favour managers in this sector that utilise name-specific shorts versus market shorts.

Relative value arbitrage: negative bias

Overall, we have a negative bias toward the relative value arbitrage category. Given current conditions for many of the trades associated with this space and the generally higher levels of leverage utilised in this sector, we believe the risk/reward is less attractive than many other opportunities that exist in other sectors. Within this strategy group, focus should be on market neutral equity and statistical arbitrage. Just a reminder, it appears that at times people forget that by definition 50% of all stocks underperform and 50% outperform the market. Therefore, at least from a theoretical perspective, managers in this sub-strategy should be able to make money. One factor to keep in mind is the dispersion of stock prices that have been coming in and could negatively impact the strategy. Convertible arbitrage is interesting as a hedge against a market dislocation-type event, however, given the current shape of the yield curve and the tightness of credit spreads, a better play would be to focus on volatility arbitrage-focused managers, or to utilise other strategies that tend to be long volatility. An allocation to multi-strategy managers in the relative value space would also be a preferred way to gain exposure.

Event-driven: aiming for the positive

Our view of the event-driven sector is positive. The primary focus is on event-driven equity managers and activists. These managers have a long bias and therefore a beta component. However they tend to be highly concentrated and focused on alpha propositions; as a result, while they may be subject to short term market moves, over time their correlation to the markets should be low. Given the volume of deal flow, merger arbitrage should remain attractive both in the US and on a global basis. We would tend to focus on global managers or European managers over US only focused funds. With credit spreads trading at very tight levels, the credit/distressed sub-strategy should be played from a conservative position. Focus should be on credit managers that know how to actively short credit and certain cash flow and asset backed lenders. Look for managers that are senior secured or in equity or managers involved in cap structure arbitrage.

Some of the same macro factors that are supportive for long/short equity managers are expected to play a positive role in the event space as well. Private equity investors and the buying power they control should be very supportive for a number of the sub-strategies in this space. As long as financing markets stay attractive, the private equity bid will support managers that are long value companies with real assets. However, remember to watch for common risk factors as correlations between these two sectors may be higher than they have been historically.

Finding the right match

The hedge fund universe is clearly comprised of many diverse strategies, and expectations for returns vary across all of them. However, the degree to which they vary is significantly less today than they have been in the past. It is our belief that this is largely a result of the decline in market volatility across asset classes and the decline in risk premium being attached to many of the markets and instruments that are traded. In part, we believe this is a function of the abundance of liquidity in the markets – money looking for a home. In our view the market has clearly become too complacent. Despite the compression of expected returns across strategies we believe one must continue to remain diversified – sample from the many different ways to take risk across the spectrum of hedge fund strategies. While we expect to see compression of returns at the strategy level, we expect to see significant dispersion of returns amongst the individual managers that comprise each of the strategy groups.

Manager selection, which has always been important when investing in hedge funds, will become even more critical in the current environment. In fact having the right managers may add greater value to a fund of hedge funds portfolio than the actual strategy allocations.

Ray Nolte is CEO Fund of Hedge Funds Group at Citigroup Alternative Investments