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Equity markets tumbled in January, particularly in Europe, but also in the United States, as the federal government threatened to regulate banks more strictly. Emerging markets also fell as China tightened monetary policy. Overall, hedge funds were able to protect against much of this decline: the Morningstar US Equity Hedge Fund Index dropped just 1.4%, less than half that of the S&P 500; the Morningstar Europe Equity Hedge Fund Index also fell 1.4%, while the MSCI Europe dropped 5.9% in January; and the Morningstar Emerging Market Equity Hedge Fund Index dropped only 1.9%, while MSCI's Emerging Market stock index declined 5.6%. Global corporate deal activity, such as mergers and acquisitions, declined in January alongside equity markets, but increased outside of the United States and Europe, driving a 1.4% rise in Morningstar's Corporate Actions Hedge Fund Index.

"Hedge funds demonstrated their ability to soften blows dealt by the markets in January, despite exhibiting generally high correlations," said Nadia Papagiannis, Morningstar alternative investments strategist.

As equities dropped, U.S. government and corporate bonds rallied. The Morningstar Global Debt and the Morningstar MSCI Specialist Credit Hedge Fund Indexes rose 0.7% and 1.7%, respectively. Convertible bonds generally did not share in the bond market's upside. The Morningstar Convertible Arbitrage Hedge Fund Index, whose funds take long positions in convertible bonds, dropped 0.3%. January proved to be a strong month for distressed debt, as restructurings and revaluations in certain cyclical industries boosted returns. The Morningstar Distressed Securities Hedge Fund Index rose 1.7%.

Derivative trading strategies, which funds in the Morningstar Global Trend, Morningstar Global Non-Trend, and Morningstar MSCI Directional Trading Hedge Fund Indexes practice, showed declines of 4.1%, 1.0%, and 1.9%, respectively, although returns of the funds within the indexes varied widely. Those funds that follow longer-term trends in equity market indexes lost out due to a mid-month selloff. Some global macro hedge funds took advantage of global currency and government bond movements, although high volatility made trading difficult.

Overall, investors pulled approximately $57 billion from hedge funds in Morningstar's database in 2009, although inflows have been apparent since June 2009. In December 2009, hedge funds in the database lost about $2 billion in aggregate, due to significant redemptions in one large multi-strategy hedge fund. Hedge funds in Morningstar's Global Equity category saw the largest inflows in December, more than $0.2 billion.

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