Hedge Funds Experience Worst Year Since 2008; Underperform Equity Markets in 2011

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HEDGE FUNDS DECLINE -0.60% IN DECEMBER

Hennessee Group LLC, an adviser to hedge fund investors, announced today that the Hennessee Hedge Fund Index declined -0.60% in December (-4.27% YTD), while the S&P 500 advanced +0.85% (-0.02% YTD), the Dow Jones Industrial Average advanced +1.43% (+5.52% YTD), and the NASDAQ Composite Index fell -0.58% (-1.81% YTD). The Barclays Aggregate Bond Index gained +1.10% (+7.86% YTD), the S&P/BG Cantor 7-10 Year Treasury Bond Index climbed +1.84% (+15.60%), and the Barclays High Yield Index gained +2.66% (+4.98% YTD).

“It was a disappointing year for hedge funds as they underperformed broad market returns for the second year in a row,” commented Charles Gradante, Co-Founder of Hennessee Group. “Hedge fund managers describe 2011 as ‘more frustrating than 2008’. High levels of uncertainty and the highest daily average volatility in 50 years resulted in managers getting ‘whipsawed’. While risk management dictated reduced exposures going into the fourth quarter, it precluded them from participating in a strong beta rally. In addition, alpha generation was extremely challenging throughout the year due to a macro-driven, high correlation environment.”

“Despite the performance struggles, we are optimistic on the outlook for the hedge fund industry. Hedge funds continue to attract capital due to their historical performance and ability to lower volatility and preserve capital. In addition, most investors understand the challenges for fundamentally-based managers in a macro driven market, and are confident they will not persist,” commented Lee Hennessee, Managing Principal of Hennessee Group. "While we are seeing some funds liquidate due to poor performance, we are seeing many quality managers closing the door to new capital as they reach capacity limits."

The Hennessee Long/Short Equity Index declined -0.77% in December and was down –3.55% for 2011. For the year, top performing funds were concentrated in better performing sectors, such as utilities, consumer staples and healthcare as well as long fixed income. 2011 was a mixed year for traditional benchmarks with the S&P closing the year flat, the Dow up (+5.52%) and the Russell 2000 down (-5.45%). Although the S&P 500 was flat, sectors showed a wide variance, with utilities performing the best, up +14.83%. Financials and materials were the worst performers, down -18.41% and -11.64%, respectively. Throughout the year, equity markets were driven by macro issues, which overshadowed strong corporate earnings and an improving economy. Several hedge funds experienced frustration in long positions where companies delivered and exceeded expectations but still declined more than the broad indices. Shorting was profitable for managers, though most report that they should have had more invested on the short side. One of the key drivers of underperformance was lack of beta participation during the strong October rally. Managers entered the fourth quarter with low exposure levels in an effort to protect capital and were caught off guard by the double digit rally in equity markets. Looking forward, managers state that equities look cheap relative to expected earnings and interest rates, but they remain concerned about slowing global economic growth and European sovereign debt issues, which should keep multiples low. However, if the European sovereign debt crisis can be contained, and there is some improvement in the housing and employment in the U.S., it would be very bullish for equities in 2012.

“Despite the fact that U.S. companies posted record profits, the market was flat in 2011. Fundamentals did not matter to investors. Rather, they were focused on the flurry of macro headlines from Europe, Asia, the Mideast and the U.S. Investors fluctuated wildly between ‘risk on’ and ‘risk off’ after the geopolitical strife in the Middle East, Japan's earthquake and tsunami, the debt crisis in Europe, and legislative gridlock in the U.S.” commented Charles Gradante. “That said, we at Hennessee Group are positive for 2012. Equity markets are priced as cheaply as they have been in decades. Corporate earnings should remain strong, and the U.S. economic recovery is picking up steam. Volatility will continue, but we think the positive fundamentals will have more relevance in 2012 than 2011.”

The Hennessee Arbitrage/Event Driven Index advanced slightly in December, declining -0.08%. For the full year, the Hennessee Arbitrage/Event Driven Index was down -2.17%, making it the best performing sub-strategy. Fixed income performed well throughout the year. In December, the Barclays Aggregate Bond Index gained +1.10% (+7.86% YTD). Treasuries were positive, as the S&P/BG Cantor 7-10 Year Treasury Bond Index advanced +1.84% (+15.60%). High yield was also positive as the Barclays High Yield Credit Bond Index advanced +2.66% (+4.98% YTD). High yield credit spreads tightened from 779 basis points to 723 basis points in December. Managers report that supply demand dynamics for credit remain strong, and they are finding attractive investment opportunities in high yield and leveraged loans. The Hennessee Distressed Index advanced +0.81% in December (-2.36% YTD). 2011 was a challenging year for distressed investing. Many managers were biased towards post reorganization equities, which remained unloved by the market. In addition, the European sovereign debt crisis shook confidence, delayed catalysts and pressured valuations. That said, managers feel conditions are improving and positions should realize value. In addition, managers are looking towards a wave of loan refinancing in 2013/14 as a significant source of opportunity. The Hennessee Merger Arbitrage Index decreased -0.08% in December (+0.18% YTD). Merger arbitrage funds ended the year slightly positive. While there were several attractive deals, high volatility and low interest rates detracted from performance. Despite a strong start, 2011 total mergers-and-acquisitions volume ($2.60 trillion) was less than in 2010 ($2.66 trillion). Europe's sovereign-debt crisis shattered the confidence of company executives to do deals despite cash rich balance sheets and low interest rates. Managers are somewhat optimistic that high cash levels and low multiples will drive merger and acquisition opportunities in 2012, especially if the Euro crisis subsides. The Hennessee Convertible Arbitrage Index advanced +0.25% in December (-1.02% YTD). On a regional basis, convertibles declined in the US and Asia, but sold off the most in Europe due to the ongoing sovereign debt concerns. Leverage is low among convertible arbitrage managers. Managers have dry powder available for when opportunities arise.

“It is still a bit early, but there are going to be some good investment opportunities in Europe. Convertible arbitrage managers are looking into the announced recapitalization of European financial institutions to meet new regulatory requirements. This will likely create attractive short-term investment opportunities as banks call securities to restructure balance sheets,” commented Charles Gradante. “It is still early due to the European sovereign debt crisis, but we could see some interesting investment opportunities coming out of Europe.”

The Hennessee Global/Macro Index declined -0.64% in December (-8.04% YTD), driven by losses in international and emerging markets. International markets underperformed domestic markets for the month and year, as the MSCI EAFE was down -1.03% for December and down -14.82% for the year. Throughout the year, international markets were battered by macro headwinds and unexpected developments, such as the Japanese Tsunami, Middle East rebellion, European sovereign debt crisis and U.S. debt downgrade. International hedge fund managers outperformed, but were still down as the Hennessee International Index fell -0.76% in December and -6.39% year to date. Many managers were positioned for a decoupling of emerging markets from developed markets and upside from continued strong growth. However, throughout the year, investors grew concerned about slowing growth and recession in the emerging markets, and markets plunged. The MSCI Emerging Markets Index lost -1.29% for the month, leaving it down -20.41% for the year. The Hennessee Emerging Markets Index was down -0.55% in December and down -12.85% for the year as hedge funds benefited from reduced exposures and hedges. The Hennessee Macro Index was down -0.48% in December (-2.14% YTD). Performance of macro funds was varied. The best performing funds were positioned conservatively, long Treasuries, TIPS, and gold. Interest rates continued to decrease in December, as debt and policy issues in the U.S. and Europe played the central role. The 10-year Treasury dropped 21 basis points during the month to close at 1.88%. The 30-year Treasury decreased to 2.90%, down from 4.34% at the end of 2010. Gold ended the year at $1,568 down from $1,751 in November due to profit taking, but still up +10% for the year. The U.S. Dollar Index advanced +2.31% in December, pushing it in to positive territory for the year, up +1.46%. The commodities run ended abruptly in 2011. The S&P GSCI declined -2.11% in December and was down -1.18% for the year.