We are no better off letting the weatherman predict the economy and the economist predict the weather… having said that, let us press on.

Stock selection:

Stock selection strategies and strategies that profit from an increase in specific risk will find more opportunities this year. The withdrawal of liquidity by central banks of US, UK, the Eurozone and the Japan over the past three years is beginning to take effect. Liquidity will diminish as a driver of financial market returns relative to fundamentals, increasing the share of idiosyncratic risk as a proportion of total risk in asset prices. This favours equity long short, event driven, credit long short strategies which are based on fundamental security selection.

Macro:

Global macro has always profited from trending markets. Trending equity markets, surging ones in some areas did not help macro in 2006. The changing face of macro is responsible. Discretionary and directional macro is out of fashion and in some cases out of businesses. Whereas in the mid 1990s discretionary macro was able to profit despite considerable uncertainty over policy by punting equity markets, today’s macro is more fixed income driven, more systematic, less discretionary. Fixed income markets have behaved erratically and counter intuitively. Whether they settle into a pattern this year is crucial to macro. As always, macro is difficult to call. Macro managers who can and do actively participate across all asset classes will find ample opportunity. Macro managers trading in fixed income land will likely continue to generate sub par results.

Event Driven:

Over the years the event driven space has grown in variety and richness. Once dominated by merger arbitrage and distressed investing there is now a growing supply of multi strategy event driven funds. Activists are a resurgent breed within the space. Merger deal flow will continue until corporate balance sheets are once again stretched. For the moment they are still relatively fat. When equity swap deals begin to proliferate will mark the time for caution. Until then, bet long on this strategy. At the distressed end, value is slowly being squeezed out of the market as default rates struggle to keep up with demand from ever sprouting hedge funds. In the convertible space, distressed investing has all but dried up from the dearth of low delta issues. The hostile activist which was in the limelight in 2005 and 2006 has lost some of its shine. High profile retractions show chinks in the armour. In emerging markets, a friendly activist still finds ample opportunities as corporates look to them for assistance.

Convertible Arbitrage:

Convertible arbitrage managers have returned to profit despite volatility remaining low. While implied vols have fallen back from the elevated levels of last summer realized volatility has risen. This has created opportunities particularly outside the US. In the US, the VIX continues to track realized volatility closely. Convertible arbitrage is more than being short implied and long realized vols. With the protracted shakeout of 2004, convertibles are showing good value. Rising deltas on the back of strong equity markets have improved the returns of synthetic puts. The trading of convertibles from a credit or equity directional view has also gained ground during gamma’s troubled years. Increasingly capital structure arbitrage, directional views on a particular stock, are expressed in the convertible market. These strategies are more exposed to event and execution risk than global trends in implied or realized volatilities.
As credit spreads have compressed across ratings, convertible bond issuance has slowed. This has implications on the competitive environment in the convertible arbitrage space. As corporate balance sheets re-lever and equity valuations become stretched, convertible bonds become a more attractive source of funding for corporate treasurers.

Credit:

In the tranched credit markets, correlations have been rising. This has provided the long equity versus senior trade some tailwind. The liquidity scenario painted above, of rising inflation and more hawkish central banks threaten this scenario as it encourages dispersion.

Credit spreads continue to decline, particular in HY where spreads are near historical lows. IG spreads remain barely wide to 10 year lows. Private equity investors continue to be active creating LBO risk and higher volatility in spreads. This is expected to continue into 2007 providing the event driven credit strategy healthy deal flow. For fundamental long shorts, LBO activity is a risk they have to manage carefully as private equity investors become less demanding and hence more unpredictable.

Asia:

Asia represents considerable threats and opportunities. Just as 2005 witnessed hedge fund assets growing in Japan on the back of high returns generated by levered long bets on the direction of the Japanese equity market, so too Asian hedge funds have printed remarkable results, also on the back of levered long bets on Hong Kong, China and India. In early 2006, the Japanese equity market wobbled and Japanese hedge funds recorded large losses. A similar risk plagues Asia ex-Japan.
Just as Japanese managers who have weathered the storm are now emerging with more reasonable and stable returns, well risk managed hedge funds in Asia will find the region a rich and rewarding space. Activists will find particularly interesting situations if they are happy to be constructive critics. Credit funds are finding improved market depth and range. Stock borrow improves daily in Asian markets while derivative technology opens up shorting opportunities in India and China.
The attraction of Asia is clear: India and China as the new engines of world growth. The complex relationships within Asia mean that obvious trends often result in counter intuitive outcomes. For the astute investor, the less efficient markets of Asia present rich pickings.

Commodities:

A four year bull market in commodities, following nearly 20 years of dead money, has led to strong interest in the asset class. This despite a very volatile and negative 2006. Interest has rotated first from precious metals in 2002 as a store of value, USD short, to industrial commodities such as base metals and energy on the China growth story, to softs and ags almost by default. A secular growth story supporting a long only exposure based investment strategy no longer works. Investors seek more intelligent trade expression which they hope to find in hedge funds. Whether they will find it is another matter. Commodities are factors of production with very peculiar supply dynamics. Too many financial traders participate in a market which should be driven by marginal cost. The result is ample alpha for the skilled trader and a high attrition rate among managers.

Reflecting the strength of global economic growth has been rising equity markets where the MSCI World index has risen 13.60% in the last 12 months. The main disappointment has been Japan where the broad market had risen but 5.84%, a number masking devastation among small and micro caps. Where investors were cautious and somewhat negative there has been a measured advance, the S&P500 rising 10.79%. European markets where there had also been some caution rose 13.77% on average. The healthier UK market managed to lag rising only 7.62%.

The highlight of the year was Asia ex Japan. Philippine and Indonesian markets gained over 40% but Asian quality markets such as Singapore and Hong Kong also managed returns of over 28%. Despite some extreme volatility in May, India rose nearly 45%. It was China that stole the show, however, as China listings in Hong Kong gained 54% and Shanghai and Shenzen listings rose by over 120%. Here an artificial construct – listing A shares at discount to H and then awaiting convergence- has been responsible for the outperformance. The market price of risk has diminished, itself a warning sign. In addition the price of insurance, implied volatility has also sunk back to levels not since for 12 years, despite a short spike in May 2006.

The prognosis for equities is favourable. While equities have risen against caution, it is the caution that makes the rise measured and sustained. Valuations are slightly stretched in the US but in Europe remain within historical limits. In Asia ex Japan, even Hang Seng valuations are undemanding. In China, however, valuations have run ahead of themselves and risk is no longer well priced. The extent of over valuation is by multiples of multiples and is indicative of an asset bubble. Lessons can be taken from Japan at the end of 2005 when a healthy market began to run ahead of itself. Japanese equities started the year in high expectations yet managed to underperform most of the major developed markets as well as Asian and other Emerging Markets as well. 2007 could well spell the same for China.

In US fixed income, as in the UK, anti-inflationary measures have lifted the short end of the curve. The long end has lagged as demand from liability matching investors has competed for yield. That said, inflationary pressures and expectations are likely to build. The US Fed has returned real rates into their 1990s neutral band and is unlikely to move any more in either direction, thus a steepening curve is to be expected. In the UK, however, real rates remain relatively low, near 2002, 2003 levels and further rate action may be expected and the curve is unlikely to steepen.

Inflation is expected to rise from 1.9% current to 2.1% for 2007 in the Euro area and from 0.3% to 0.4% in Japan so curve steepening is also likely in EUR and JPY. ECB policy remains hawkish but is unlikely to go too much further as real rates have returned unto mid 1990s range. In Japan, the BoJ is unlikely to raise rates soon given past history.

Credit spreads actually tightened through 2006 and continue to compress. Demand for yield, healthier corporate balance sheets and robust earnings growth underpins the credit markets. The level of caution resulting from the immense growth in the CDS market has also worked to focus attention on risk and prolong the credit bull market.

On almost every front, the outlook is benign. In the absence of some major disruption on the geopolitical front, current trends are likely to continue. Any changes in direction are likely to be smooth. It is a feature of major trend reversals that they are unforeseen and that the reasons for their happening are not well understood until well after the fact. What risks are at the forefront of investors attention rarely precipitate substantial disruptions. Let’s list some of them.

• Imbalances in US current account versus the rest of the world but particularly with China and Opec.

• The state of the US housing market and the impact on consumption.

• The size of the credit derivatives market.

• The impact of hedge funds on financial markets.

• The weight of capital flowing into private equity.

• The rich poor divide which cuts between but increasingly across countries.

• The eerie calm that greets geopolitical events of late

We would like to know what risk we are running in our portfolio which consists of a clutch of hedge funds. To do this we measure the individual volatilities of each hedge fund. We also need to know how these funds relate to one another.

Question: Do we measure the correlation of returns of each fund with another? Or should we find out what each fund has in its portfolio and measure the relationships between portfolio components?