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“January was a challenging month as the equity rally was short lived and reversed course mid-month. Managers were defensively positioned with low net exposures and were able to limit losses,” commented Charles Gradante, Co-Founder of Hennessee Group. “While 2009 was all about market beta, 2010 is going to be a year driven by alpha. Security selection will drive outperformance. We are already seeing greater dispersion and lower correlations, which should benefit hedge funds.”

“Hedge funds outperformed broad equity benchmarks in January on a relative basis,” said Lee Hennessee, Managing Principal of Hennessee Group. “Managers suffered losses in long positions during the second half of the month, which more than offset early month gains and profits made shorting.”

The Hennessee Long/Short Equity Index declined -0.86% in January (-0.86% YTD) as major equity indices finished the month in the red; both the S&P 500 Index and Russell 2000 Index finished January down -3.7%, while the Dow Jones Industrial Average lost -3.5%. Despite respectable earnings, particularly from financial firms, and positive economic data, stocks retraced in January as China moved to tighten lending, and investors grew concerned about global growth. Also contributing to the downturn in stocks was uncertainty surrounding the Obama administration’s renewed push for more strenuous regulation against banks.

From a sector perspective, health care was the sole sector to experience gains in January with a +0.4% return. Health care stocks, which hedge funds are overweight, were buoyed by strong gains in biotech as well as by the special Senate election in Massachusetts which was won by Republican Scott Brown and is likely to complicate President Barack Obama's proposed overhaul of the U.S. health-care system. Telecomm (-9.3%), technology (-8.5%) and materials (-8.7%) stocks experienced the sharpest declines during the month of January, while the KBW Bank Index jumped +9.0% on better than expected earnings from some of the major financial institutions.

“One of the greatest concerns for managers is the sustainability of the current economic recovery given that government stimulus cannot continue at its current pace. The stimulus has not helped the private sector, which is largely responsible for creating new jobs,” commented Charles Gradante. “Rather, the government is looking to increase regulation on business and banks, as well as increase taxes, which will further disinterest businesses from investing. The government needs to incentivize the private sector to take risk. Many managers are stating that one of the key sources of volatility and unpredictability is the potential for political risks from Washington.”

The Hennessee Arbitrage/Event Driven Index advanced +0.64% in January (+0.64% YTD). Multiple arbitrage managers are optimistic on 2010 and stress that security selection will drive outperformance. Most are positioned conservatively with modest leverage, low net exposures, and high diversification. Spread on the Merrill Lynch High Yield Index widened slightly from 639 basis points to 654 basis points during the month. The Hennessee Distressed Index increased +1.06% in January (+1.06% YTD), as a positive yield offset a slight widening of spreads. Managers state that while it appears that the default rate will moderate in coming months, there is a significant overhang of challenged companies and distressed opportunities. Managers report that muted GDP growth, high leverage, and significant maturities should benefit distressed investing for several years. They are optimistic on distressed exchange offerings as companies with lite covenants are able to avoid bankruptcy and provide interesting trading opportunities.

The Hennessee Merger Arbitrage Index advanced +0.40% in January (+0.40% YTD). Managers benefited from Kraft and Cadbury reaching an agreement and closure in Disney-Marvel and Oracle-Sun Microsystems deals. Managers state that annualized deal spreads are 8-10%, which are relatively attractive. After two years of declining volume, managers expect an acceleration of M&A activity as companies with high cash levels will attempt to grow revenue through acquisitions and increase their global presence. The Hennessee Convertible Arbitrage Index returned +0.23% (+0.23% YTD). Positive contributions from interest rates, volatility and a positive carry were offset by cheapening in the secondary market. Opportunistic buying in the first week of the year faded quickly as many were selling into the strength. Managers indicate that leverage and financing has improved, allowing funds to enhance returns.

“At the heart of a long-term global recovery is China allowing it's currency to float. No other country is more responsible for global unemployment than China. They are the world’s largest exporter,” said Charles Gradante. “Besides concerns about a protracted recession, hedge fund managers have a new concern, inflation in emerging markets, especially India and China. Inflation in the emerging markets could be exported to developed nations.”

The Hennessee Global/Macro Index declined -0.97% in January (-0.97% YTD). International equities declined sharply in January as investor’s risk aversion increased, with the MSCI EAFE Index declining –4.44% (-4.44% YTD), in line with U.S. markets. The Hennessee International Index fell -1.01% (-1.01% YTD) as managers maintained low net exposures. Managers remain concerned about issues in Europe as Portugal, Italy, Greece and Spain threaten to undermine the Eurozone. Russia was a bright spot for international equities, strengthening in January, while most other emerging markets saw declines. The Hennessee Macro Index declined -0.39% for the month (-0.39% YTD). Many macro managers took losses long equities as they expected a continued market rally due to improving growth forecasts and accommodative monetary policy. Some managers were able to profit from the continued dollar rally, as excessive dollar pessimism continued to unwind. The strengthening in the dollar has also forced many to unwind the dollar carry trade. Managers suffered losses in gold, as prices fell to a three-month low of $1,044, and oil, as crude prices sharply retreated on economic growth concerns.

“Managers have told Hennessee that recent comments from the Fed may hint that the US dollar will continue to strengthen. In the January minutes, it was stated ‘The Federal Reserve will also be working with its central bank counter parties to close its temporary liquidity swap arrangements by February 1’.” stated Charles Gradante. “Closing swap lines will reduce dollar liquidity resulting in a rise in the Dollar index.”

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