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March

Before we get into the meat of this latest newsletter, I wanted to let you know that our company, Clade Investment Management, is now up and running and our web site address is www.cladeinvest.com. If you would like to find out more about what we are doing take a look there.

In previous editions of the newsletter I started a series on hedge funds, the aim of which was to provide you with information about this relatively new asset class. Please go to our web site, in case any of you would like to revisit some of the previous concepts raised. An additional objective of this newsletter is to turn the vast amount of economic data you receive from various sources, into information which hopefully is useable through analysis and interpretation from our team at Clade.

So far, the following points about hedge funds have been made:

1. Hedge funds generally protect capital when markets are falling;
2. Hedge funds outperformed equities over the past 5 years on a risk adjusted basis (i.e. investors in hedge funds took on lower risk and got better returns than traditional equity funds); and
3. Hedge funds are not a fad. They are becoming an important part of the asset allocation decision of individual and institutional investors.
4. Hedge funds use short selling to reduce risk and preserve capital. They also use leverage to increase returns.
5. Hedge fund managers use an absolute return benchmark, i.e. the performance of hedge funds is not correlated to the market, and they charge performance based fees.
6. Hedge fund managers put their own cash into the funds so that their interests are aligned with investors.

Economic news

	Current exchange rates	Current exchange rates
ZAR/USD	5.95	5.95
USD/Euro	1.33	1.30
USD/GBP	1.91	1.87

On the economic front, the dollar once again, behaved according to predictions by tending weaker during the six weeks. The USD has lost approximately 2% on the crosses with the Euro and GBP since the end of January. The US Fed pushed up their interest rates, as predicted, by 0.25% during February. The current account deficit continues to balloon as spending in the US continues unabated. The rise in rates does not seem to be having a dampening effect on the US economy; in fact concerns about inflation are starting to come to the fore.

Oil

Oil prices continue to be driven by demand. Industrial output in China grew to16.9% in January, so this degree of consumption is having a profound effect on the demand for commodities in general, and in particular oil. I had forecast that oil would remain in the USD45 - USD50 per barrel range for the foreseeable future. However it has in fact climbed about 20% higher to USD53 per barrel and there are many commentators who say it is headed for USD60 per barrel in the near term. This is because OPEC is currently pumping oil at the top end of their capacity and alternative oil suppliers need to come on line for prices to decline. So, as supply looks constrained there has to be an effect on prices, and that is unfortunately upwards. Concerns about inflation and a negative performance on the global economy thus remain.

An important point to consider about the current price of oil is the Euro equivalent of the price. Given that the USD has devalued by about 40% against the Euro since the beginning of its decline 3 years ago, one can see why there has been a muted effect of the increase in the oil price on the global economy. The current Euro price per barrel is still below the highest level it has reached in recent times. If we see a strengthening dollar we should see a greater impact of the oil price on global inflation (i.e. rise in inflation) and a decreased economic output.

ZAR/USD

As I mentioned last month, the rise in interest rates in the US would lead to a weaker ZAR in spite of a weaker dollar. The ZAR moved from 5.95 to 6.27 immediately after the rise in US rates. The rate has subsequently firmed as a result of USD weakness where it is currently hovering at around the 5.95 level.

There is some speculation regarding what is driving the recent performance of the ZAR. Is it the decline in the USD or has there been a genuine strengthening of the ZAR over the past year? I have assessed the performance of the USD and the ZAR against the major global currencies to assess the trends. The analysis of the USD is set out in the table below:

USD performance from March 2004 to March 2005

	Euro	AUSD	GBP	ZAR	NZD
Average	1.2521	0.7383	1.8410	0.1596	0.6702
High	1.3644	0.7945	1.946	0.1792	0.7279
Start value	1.2498	0.7718	1.8701	0.1507	0.6877
End Value	1.3114	0.7832	1.908	0.1684	0.7274
Depreciation	5%	1.5%	2%	11%	5.77%

As can be seen, the USD devalued between 1.5% and 5% against the major currencies during the past year and by about 11% against the ZAR. If we look at how the ZAR has performed against the major currencies, we see the following:

ZAR performance from March 2004 to March 2005

	NZD	USD	AUD	GBP
High	4.6488	7.07	5.2142	12.6428
Average	4.225791	6.31907	4.658767	11.61998
Low	3.8881	5.6265	4.3067	10.7919
Start Value	4.5884	6.672	5.1492	12.4773
End Value	4.3565	5.9892	4.6907	11.4274
Appreciation	5%	11%	8%	8%

So the overall conclusion is that even though the USD has depreciated, and this accounts for some of the appreciation of the ZAR against the USD, there has been an overall appreciation of the ZAR by between 5%-8% across the board over the past year.

The reason I believe the ZAR has performed so well, is due to the reduction in the inflation differential between SA and our overseas trade partners and also due to the reduction in the "risk premium" attached to SA. SA inflation used to be at about 12% and our partners at about 3%. The differential was therefore about 9%. Currently however, SA's inflation is much lower at about 4% with our main trading partners at about 2%. However, the interest rate differential between SA and our major trading partners remains significant giving offshore investors handsome real returns thus increasing the demand for the ZAR and bringing the price of the ZAR down.

In addition SA Inc. traded at a discount to its fair value for many years because of issues such as problems in Zimbabwe, and general uncertainty in the Southern African region. However, one only has to look at the latest positive comments by various rating agencies, to get a general sense of improved sentiment by foreigners regarding SA, leading to improvements in the credit ratings of SA Inc.

As with China, there are in deed benefits of SA having a concentration of political power by one party. Trevor Manual (together with the excellent Pravin Gordhan, who heads up SARS) and Tito Mboweni can run the money matters of our country with a ten year (and longer) view because there is very little chance that someone else other than the ANC will be managing the economy in future. By contrast India with its fluid democracy, suffers an unusual consequence; frequent changes in economic policy resulting from frequent changes in power (Economist, March 11). The net result of both the reduction of inflation and the stability of fiscal management has been a positive effect on the ZAR giving offshore investors real returns on SA bonds at reduced levels of risk.

Most of this good news is now priced into the current value of the ZAR so I don't see this having any further positive effect on the exchange rate. My view thus remains that we are likely to see the ZAR weaken as rates in the US rise, driving down the real returns foreign investors receive by holding ZAR. This will be offset to some degree by a weaker USD.

It is my opinion that the change in interest rates offshore will have a greater effect than the weakening trend of the USD so there is likely to be a gradual weakening of the ZAR against the USD and across all currencies during 2005 and 2006. This weakening bias will also lead to a sell off of SA bonds by the foreign investors and it is likely that this will have a further weakening effect on the ZAR.

SA interest rates

As mentioned last month, I did not foresee a reduction of interest rates in SA when the MPC met in February. This was due to the effect that lower interest rates would have impacted negatively on the ZAR. Lower rates would also have been inflationary as a result of the stimulatory effect of lowering borrowings. Rates were in fact left unchanged. It is my view that the SARB will continue to maintain a very conservative stance and keep rates stable in April.

Hedge Funds

Depending on whom you ask, there can be up to15 different strategies hedge fund managers use to make profits. Understanding these strategies is crucial to understanding what the differences between the various hedge funds are. In this issue I am going to explain some of the strategies which hedge fund managers use in order to give you a broad understanding of how they make profits for their clients.

Strategies and examples

Hedge fund managers can be classified in a multitude of ways and there is no standard system. There are a number of hedge fund indices developed by financial services companies (i.e. S&P, MSCI, HFR etc) each with different characteristics and classification methodologies which attempt to track the performance of hedge fund strategies globally.

The most consistent classification is based on the process or strategy that a fund employs and the asset class used. The process describes the methodology that managers follow when creating positions, and managing their portfolios and investment risk. Generally, these strategies can be further divided into directional and non directional strategies.

Relative Value Strategies

Relative value strategies or arbitrage strategies use mispricing in a specific asset or security to make profits. In other words, the price of an asset relative to another asset is perceived by the manager to be wrong e.g. a manager buys a parcel of different convertible bonds (which gives the owner a right to purchase a share in the company). The price of the individual convertible bonds when sold separately may be worth more than the parcel.

The profits managers make in these strategies are not dependent on the direction of the market. Leverage is often used in these scenarios and some funds can be leveraged up to 10 times.

Event Driven Strategies

These strategies use corporate events such as mergers, restructurings, liquidations and bankruptcies to buy and sell shares. In mergers for example, the current value of a share may be different to the future value of the combined entity. Managers will thus buy the share of the target company expecting to pick up on the enhanced value of the merger or the manager may short sell the share of the acquiring company if they think the new entity will be worse off i.e. Compaq/HP merger!

Distressed Debt

Distressed debt managers buy corporate or government bonds where the company or government is in default or bankrupt. These securities are thus below investment grade and often trade at a discount to their value. Consequently the investors expect to make a capital gain from the trade, once the company or government is back on their feet, rather than from generating an income stream from the interest. So once again, in these instances profit is made irrespective of the direction of interest rates or the market as a whole.

Opportunistic Strategies

These strategies are dependent on the hedge fund manager’s view on what is happening in the market. Consequently these strategies have a higher risk than relative value or event driven strategies because they rely on the direction of the markets.

Managers will buy or sell a security based on their view of the current price (either over or undervalued). Thus the strategy is heavily reliant on the skill of the manager in understanding the value of the security.

These funds take positions along the whole spectrum of risk and managers try to distinguish their performance from the asset class as a whole. Returns thus deviate from the underlying market returns.

Global Macro

This strategy is the most flexible of investment strategies with the manager taking a top down approach investing in anything using their ability to forecast changes such as interest rates, exchange rates and liquidity. For example a manager may take a position which benefits from an interest rate hike in SA, because the SA currency will appreciate against the USD.

OK, that’s about as much detail as I think is necessary right now. I wanted to give you a broad understanding how hedge fund managers make profits. I will post much more detail on our web site for those of you who would like the finer points in some of the strategies.

 

© Copyright, Clade Investment Management, 2007