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Charles Gradante

“Hedge funds had a decent start to the year as the environment for stock picking improved. Some managers struggled to produce profits as short portfolios detracted from performance,” commented Charles Gradante, Co-Founder of Hennessee Group. “The general consensus among hedge fund managers is that the economy is improving and markets should continue to advance in the short term. That said, managers are aware of several key macro risks that have the potential to cause volatility throughout the year, including the European Sovereign debt crisis, emerging market inflation, and fiscal imbalances in the U.S.”

“Managers are encouraged by declining correlations among stocks and sectors. As companies reported earnings in recent weeks, stocks started to respond more to fundamentals,” said Lee Hennessee, Managing Principal of Hennessee Group. “As a result, managers are finding attractive opportunities on both the long and short sides of the portfolio and are increasing gross exposure levels. Net exposures have remained somewhat constrained as many are concerned about a possible pullback after a strong two month rally.”

The Hennessee Long/Short Equity Index advanced +0.39% in January (+0.39% YTD). Stocks continued to push higher in January on solid economic reports, strong earnings reports and increasing M&A activity. Managers report that the environment for stock-picking improved as correlations continued to decline, equity market inflows increased, and investors started actively allocating capital to new ideas.

Long / short equity hedge funds were able to generate gains in January, however lagged on a relative basis as shorts and other forms of hedging continued to serve as detractors during the ongoing market rally. In contrast to 2010, small cap stocks lagged large cap stocks during the month as the Russell 2000 Index slipped -0.3%. Value outperformed growth, as the S&P 500 Value Index rose +3.2% while the S&P 500 Growth Index rose +1.5%. Energy was the top performing sector during the month (+7.3%), followed by industrials (+4.3%) and technology (+4.2%). Telecommunications (-2.8%) was the weakest performing sector during the month. Consumer staples (-1.6%) and consumer discretionary (-0.7%) also experienced weakness during the month as investors grew increasingly concerned that rising energy prices could effect personal consumption going forward

“Recent political trends in the U.S. are encouraging for the equity markets. The recent extension of the Bush tax cuts and increasingly more pro-business rhetoric from the current administration are certainly positive developments. As we are enter a third year of a Presidency, there tends to be greater focus on stimulating the economy and spurring growth,” commented Charles Gradante. “I think this is a positive for merger and acquisitions activity as CEOs will gain more confidence and start to deploy record cash stockpiles.”

The Hennessee Arbitrage/Event Driven Index advanced +1.82% in January (+1.82% YTD). Along with a strong equity market rally, credit markets also advanced for the month, with the exception of Treasuries. Spreads on high yield bonds tightened to 468 basis points, the narrowest level since November 2007, according to the Bank of America. Managers report that with high yield bonds trading below the long-term average spread, they do not see the current market as particularly overvalued or undervalued. While there is potential for additional narrowing as fundamentals continue to improve, managers believe that security selection is going to be vital in generating gains going forward. The Hennessee Distressed Index increased +2.13% in January (+2.13% YTD). Long-biased portfolios benefited from the continued market rally.

For the first time since 2007, there were no corporate debt issuers rated by Moody’s that defaulted during the month. The U.S. speculative-grade default rate fell to 3% from 3.4% in December and from 13.7% a year earlier. The Hennessee Merger Arbitrage Index advanced +1.22% in January (+1.22% YTD). There has been a flurry of new deal announcements to start the year. As companies have record cash balances to pursue attractive assets, managers expect robust activity going forward. While managers state that deal spreads are narrow, the risk of a deal break is lower, and there is greater potential for competitive bidding situations as companies contend to acquire the best assets. The Hennessee Convertible Arbitrage Index returned +2.00% (+2.00% YTD) as the convertible space richened in January. Convertible arbitrage players increased leverage after most were positioned relatively conservative in December. Non-traditional outright buyers of convertibles remain very active, demonstrated by news that PIMCO may begin purchasing convertibles. That said, convertible new issuance remained disappointing with only $6.6 billion priced in January, driven by only a few large deals.

“After rising for a tenth consecutive year in 2010, gold prices began 2011 by declining -5.6% in January. Gold sold off due to profit taking and investors selling safe haven assets in favor of higher risk assets,” commented Charles Gradante. “Many hedge fund managers believe that a correction may continue in the short term. However, longer term, many are still very bullish on gold as there are concerns that countries will continue to debase their paper currencies, which could result in a significant rally in gold.”

The Hennessee Global/Macro Index declined -0.22% in January (-0.22% YTD). International equities advanced, driven by Europe, as the MSCI EAFE Index increased +2.30% (+2.30% YTD). International managers underperformed due to overweight exposures in Asia and emerging markets. Emerging market equities fell during the month, even as developed market equities continued to rally. Managers remain concerned with emerging market inflation, policy tightening, and the potential for a “hard landing”, especially in China. In addition, managers are closely monitoring the political and social unrest in North Africa and the Middle East. The Hennessee Macro Index declined -0.95% for the month (-0.95% YTD). While managers generated gains long equities, energies and agricultural commodities, long positions in metals and currencies significantly detracted from performance.

In the currency markets, the euro currency gained against the U.S. dollar as Europe continues to show signs of stabilization. Managers lost money on currencies of commodity exporting countries, which declined on fears that China’s attempt to temper growth will reduce demand for materials. Positions in precious and base metals detracted from performance, especially gold and silver. Managers generated gains long agricultural commodities as wheat, cotton, cocoa and sugar all advanced.

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