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Nadia Papagiannis

Global stock markets bounced back in July, especially in Europe, as concerns over the debt crisis eased. European-equity-focused hedge funds missed out on much of the market rally, however. The Morningstar Europe Hedge Fund Index increased 5.6%, while the MSCI Europe NR Stock Index rose 11.6%.

"Confidence returned to the markets in July," said Nadia Papagiannis, alternative investments strategist for Morningstar. "But hedge funds are aware that the positive sentiment may be fleeting, and are thus prepared for another downdraft."

A rebound in the stock markets and investor sentiment, especially in Europe, also helped corporate event-driven hedge funds, which trade stocks of companies involved in mergers and tender offers, to post significant gains. The Morningstar Corporate Actions Hedge Fund Index rose 3.2% in July and is up 7.3% for the year to date. Deal volume improved in July in Europe and Asia but is still down year over year in developed markets.

The credit markets recovered in July. Positive corporate earnings surprises, stress tests of European banks, and a falling default rate led to a narrowing of credit spreads, especially in high-yield debt. Tightening spreads spelled profits for long-biased debt and fixed-income arbitrage hedge funds. The Morningstar Debt Arbitrage Hedge Fund Index rose 3.1% in July. Convertible bonds also benefited in July, and the Morningstar Convertible Arbitrage Hedge Fund Index increased 3.5% for the month.

While many hedge fund strategies returned to profits in July, hedge funds that take macro-economic bets using derivatives continued to suffer. The Morningstar Global Trend and Global Non Trend Hedge Fund Indexes gained only 0.6% and 0.7%, respectively, in July. Theses indexes finished the year though July 31 down 2.4% and 1.0%, respectively. Trend-following hedge funds profited from rallies in wheat and the decline in the U.S. dollar in July, but reversals in the stock index and Treasury bond market caused losses.

Although multi-strategy hedge funds and hedge funds of funds saw positive outcomes in July, the Morningstar Hedge Fund of Funds Index remains in the red for the year to date through July 31. Through June 30, multi-strategy funds in Morningstar's database experienced net outflows of $2.8 billion, the largest of any category. Funds in Morningstar's Global Non Trend and Corporate Actions hedge fund category saw the largest net inflows in the first six month of the year of $2.6 billion and $2.3 billion, respectively. Overall, funds in Morningstar’s hedge fund database saw outflows of $1.6 billion through June 30.

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