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Hedge Funds Produce Positive Return in November, Naked CDSs Pose Major Risk (December 13, 2004)

Location: New York
Author: Alexander Smith-Ryland
Date: Monday, December 13, 2004

Hedge funds produced a positive return of +2.75% in November, bringing the 2004 year to date return to +5.98% for the Hennessee Hedge Fund Index. The broad market indices were also positive for the month, as the S&P 500 DRI Index climbed +4.47% (+7.66% YTD), the Dow Jones Industrial Average rose +4.00% (-0.24% YTD), and the NASDAQ Composite Index gained +6.17% (+4.68% YTD).

"Our research dialogue with hedge fund managers is confirming the observation Hennessee Group made to its clients earlier this year. Then and now, we can continue to be concerned about hedge funds who are writing and issuing credit default swaps (CDS), without owning the underlying bond, for the sole purpose of increasing performance," stated Charles Gradante, Managing Principal of Hennessee Group LLC. "If we have a credit event, several hedge funds may face systemic portfolio problems. We are not only seeing this trade among credit arbitrage managers, but also among equity hedge fund managers who recognize the risk of naked put writing, but are confident in the credit risk."

The Hennessee Regulation D Index was the top-performing index in November, with a return of +7.07% (+17.78% YTD). Companies are continuing to receive favorable funding, as interest rates remain low, and are not significantly affected by rising raw material prices. The second best performer for the month was the Hennessee Latin America Index with a return of +4.43% (+11.95% YTD). The recent market prosperity has led investors to become less risk adverse and Brazil , the region's largest economy, posted a 3rd quarter GDP of 6.1%. Returns were further boosted by a decline in unemployment for the second month in a row. In third position was the Hennessee Pacific Rim Index, posting a return of +4.22% (+5.10%YTD). Japan was the main driver as investors saw easing deflationary pressures, increasing pricing power in discretionary items (shoes, clothes, etc.), and an increase in land prices (the first in 20 years.)

"Arbitrage hedge fund managers have shifted from a yield curve 'flattening' spread trade to a yield curve 'steepening' trade. The bond futures market is signaling a move in the 10 year Treasury through its resistance at 4.5% and up to 5.0%, indicating a major trend reversal," stated Mr. Gradante.

The Hennessee Short Biased Index was the worst performing strategy for the third month in a row, with a decrease of -9.00% (+1.57% YTD), as the broad markets continued their fourth quarter rally on the decline in oil prices and the resolution of the Presidential election. The Hennessee Convertible Arbitrage Index was the second worst performing strategy, posting a gain of +0.75% (+0.79% YTD) as, following two months of negative performance, the price of convertibles was bid higher due to strength in US equity markets and selective new issuances. The third worst performer was the Hennessee Market Neutral Index, posting a return of 0.83% (+2.16% YTD) as the strength in the equity markets made it costly to keep a short portfolio.

"Equity hedge fund managers have reported to Hennessee Group that the markets are wound up like a rubber band and are ready to unwind. Managers point to low spreads over Treasuries, a flat yield curve out to the 10 year, and volatility [VIX] hovering conspicuously in the mid-teens," concluded Mr. Gradante.

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