The Culross Global Fund was shortlisted in the ‘Global Multi-Strategy $100m – $500m’ category at the Investhedge Awards 2008.

The Culross Global Fund was shortlisted in the ‘Global Multi-Strategy $100m – $500m’ category at the Investhedge Awards 2008.

During 2008, the crisis that began in US Subprime Mortgages became a Global Financial crisis. We expect 2009 to be the year in which it spreads far beyond property and finance to be felt acutely in the real economy globally. Precipitate falls in a wide range of indicators of economic activity warn of this. Economic Policy and the tools used to advance it are unrecognisable from 6 months ago. For Governments to take responsibility for addressing these problems quickly must be good and their actions are broadly helpful. But we do not know how fast these actions will take effect, or what their entire impact will be. The political climate has also changed totally. Government intervention to address the shortcomings of markets is now the standard. While we confront deflationary slowdown today, fiscal laxity and printing money increase the ultimate threat of inflation. Social and taxation policy will change to redress the excesses of the era of ‘greed’. This feels like a different world.

In December, the H fund was up 2.16%. The best performing theme was Japan Corporate Event Opportunities which also generated a strong return for the year. Asian Consumer Power made a welcome positive contribution. The Global Financial Sector theme made a solid profit as did Dislocation Insurance. This theme was first introduced into the portfolio to offset the danger posed to our Asian specialist managers in the event of a slowdown in global growth. In the sense that the theme produced a strong positive return in 11 out of the past 12 months this hedge worked. But the scale of the returns was insufficient to offset the losses incurred over the year in Asia and, in hindsight the weighting of the Asian theme was not reduced fast enough. Although its economies have weakened, Asia faces a much more positive economic future than any other region. Our 3.6% weighting in the theme represents an option on recovery.

For the year 2008, the Fund was down 10.45%. In addition the Asia, the BIC Independent Growth caused losses in the final third of the year. Small Cap (2% weight today) & Technology (now zero) also subtracted from performance. Even the best stock pickers are susceptible to being crushed in this environment.

Over the year, we saw a positive contribution from the Global Financial Sector theme, another of the ‘hedging’ themes in the portfolio, along with Dislocation Insurance and Credit Spreads in Transition. The Credit theme represents the greatest frustration of 2008. Three of the four managers involved were profitable or very profitable. But one lost enough money to tip the whole theme negative. As credit melted down, his view of the fundamentals convinced him that markets were overstating default risk and understating recoveries, so, as they became more costly to maintain, he reduced his hedges. He may be vindicated in future, but the mark to market hit leaves a bitter taste in the meantime. As we enter 2009, these three ‘hedging’ themes continue to offer good opportunities.

There has been no change in the liquidity of the underlying funds in the portfolio since our last report.

During 2008, the crisis that began in US Subprime Mortgages became a Global Financial crisis. To recall how much the world changed during the year, consider this. Late in 2007, in a contested takeover, RBS paid $100bn for the bulk of ABN Amro Bank. If they had waited a year, in mid November 2008, the same sum matched the market cap of Citibank, Goldman, Morgan Stanley, Merrill Lynch, Deutsche Bank and Barclays together with $8bn left over. Today, RBS is majority owned by the UK Taxpayer and its shareholders are on the point of being wiped out completely.

We expect 2009 to be the year in which the crisis spreads far beyond property and finance to be felt acutely in the real economy globally. Precipitate falls in a wide range of indicators of economic activity warn of this. Economic Policy and the tools used to advance it are unrecognisable from 6 months ago. For Governments to take responsibility for resolving these problems quickly must be good and their actions are broadly helpful. But we do not know how fast these actions will take effect, or what their entire impact will be. The political climate has also changed totally. Government intervention to address the shortcomings of markets is now the standard. While we confront deflationary slowdown today, fiscal laxity and printing money increase the ultimate threat of inflation. Social and taxation policy will change to redress the excesses of the era of ‘greed’. This feels like a different world.

In December, the fund was up 2.5%. The top performing themes were Japan Corporate Event Opportunities, Global Inflation Transition and Dislocation Insurance, an impressive result given that, for once, there was no new dislocation to insure. The Global Financial Sector theme also made a solid contribution. No themes lost money although four were flat.

For 2008, the Fund was up 3.21%. Given the environment, the ‘Hedging’ themes did best over the year. The managers in Dislocation Insurance did well, the best of them up nearly 40%, a return exceeded by the manager holding the largest allocation in the Financial Sector theme. Credit Spreads in Transition generated a solid profit too. Four of the five managers in our Japan theme made double digit returns. The Japanese equity market did not yield these results readily in 2008. US Recession Opportunities was the fifth profitable theme in the portfolio.

Asia Consumer Power generated the greatest loss but it remains the most interesting option on future GDP growth anywhere. We also lost money in Europe and have cut the allocation, while the losing Technology theme exited the portfolio entirely at the year end. The Global Inflation in Transition theme was introduced to the portfolio in mid year. It did not make money in 2008, but we expect the forces of inflation and deflation now ranged against one another to engage in a mighty struggle in the future.

During 2008, the crisis that began in US Subprime Mortgages became a Global Financial crisis. To recall how much the world changed during the year, consider this. Late in 2007, in a contested takeover, RBS paid $100bn for the bulk of ABN Amro Bank. If they had waited a year, in mid November 2008, the same sum matched the market cap of Citibank, Goldman, Morgan Stanley, Merrill Lynch, Deutsche Bank and Barclays together with $8bn left over. Today, RBS is majority owned by the UK Taxpayer and its shareholders are on the point of being wiped out completely.

We expect 2009 to be the year in which the crisis spreads far beyond property and finance to be felt acutely in the real economy globally. Precipitate falls in a wide range of indicators of economic activity warn of this. Economic Policy and the tools used to advance it are unrecognisable from 6 months ago. For Governments to take responsibility for these problems quickly must be good and their actions are broadly helpful. But we do not know how fast these actions will take effect, or what their entire impact will be. The political climate has also changed totally. Government intervention to counter ‘market failure’ is now the standard. While we confront deflationary slowdown today, fiscal laxity and printing money mean that the ultimate threat of inflation has increased. Social and taxation policy will change to redress the excesses of the era of ‘greed’. This feels like a different world.

In December, the fund was up 0.8%. Equity Pairs Arb and Mortgage Arb produced neutral results while the 4 other themes were profitable. Convertible Arb began the long road back to health from the dire conditions that prevailed in October and November and returning market normality allowed the Instrument Arb specialist to record his best month of the year.

The Fund was down 4.18% for the year. Of the six themes in the portfolio, four made positive contributions, two detracted. Fixed Income Arb made a small loss. Without Convertible Arb, the portfolio would have broken even. Both of these markets suffered large scale dislocation in the second half of 2008. By contrast, one Mortgage Arb manager recorded a double digit result. US mortgage securities have high positive carry, Government backing and intricate interest rate optionality. Most investors are petrified of them which only adds to their appeal to the expert Arbitrageur. Merger Arb made money because our conservative managers restricted their exposures to agreed deals without funding risk. The credit famine led to a big increase in these spreads. Big corporate balance sheets are generally strong. The advantages of strategic acquisitions at declining prices will not disappear in 2009. With liberal provision of Central Bank funding, the frozen plumbing of financial markets is thawing out, underpinning the positive prospects for Arbitrage returns.

The patchwork of US Government policy innovations designed to address the crisis has continued to grow, and with it, the Fed’s balance sheet. When Citibank needed rescuing in late November the mechanism chosen included a mixture of fresh capital and the underwriting of weak assets. The TARP was not central to that effort, but the Fed was. Since the crisis started, the non-Treasury assets on the Fed’s balance sheet have exploded, from $80bn to more than $1.7t. ‘Quantitative Easing’ sounds technical but in plain terms involves printing money, and the Fed’s purchase of Agency mortgage bonds in late November was just the beginning. It was done to shrink the spread on mortgages, a clear policy target. We are now watching for direct intervention in the shape of the yield curve and other spreads in future, as the wider the policy interventions become, the more of a challenge it will become to convince markets that Governments can afford the cost. Against this backdrop, our Global Inflation Transition theme made a profit in November, and whilst for now, it is the threat of deflation that is moving markets, the widespread abandonment of both fiscal and monetary discipline makes this a welcome addition to our ‘hedging’ themes. Repeated recent failures to complete Government bond auctions on acceptable terms serve as a warning for the future.

In a month when equity indices lost ground, six of our themes made money. The largest return came from the two managers in the Global Financial Sector Dislocation theme. All three Dislocation Insurance managers were profitable. Japan Corporate Event Opportunities has been one of the most consistent contributors to our returns this year. In November, 4 of its 5 managers made money. Asian equity markets did better than the average and the Asia Consumer Power theme made a positive contribution. Of our two largest holdings in the Credit Spreads in Transition theme, one was net short in November and the other was definitely long, and yet frustratingly they both lost money. Credit spreads are still trading at outlandish levels. Commentators want to extrapolate the past relationship between spreads and subsequent default rates in order to see what is in store, and the alarming results suggest that if IRAX Crossover Index spreads are above 1000bp’s then 50% of these bonds will default in the next 5 years. This is a forecast that the world will soon stop turning. A better explanation is that credit markets are not working well enough to offer useful predictions of what is to come. This dysfunction causes frustration and alarm for investors today, but the pick of these mispriced assets will reward their owners richly in due course.

Since our report a month ago one legacy position amounting to 0.2% of NAV of our fund has restricted liquidity. As always, please contact us with any questions you may have.

Our largest Fixed Income Arb manager was vindicated in November as the relationship between cash US Treasury bonds and the pricing of Futures contracts reconnected as a result of the regular rolling of contracts from one period to the next, and valuations sprang back to early October levels. This is not to say that normal service has been resumed, as the Fixed Income market faces monumental new supply of Government Bonds issued to finance bail outs and fiscal stimuli. Markets will need to be incentivised to buy these new issues, temporarily changing the value relationship between very similar securities and generating arb opportunities. Fed Funds still trade at something close to zero despite an official rate of 1%, which does not help to improve the working of the repo market as the cost of deferring the settlement of a trade is negligible, but the Authorities have begun to act and an improved repo mechanism is under discussion, which may include a fine for fails. The smaller holding in this theme in the portfolio is still struggling and is to be redeemed.

Mortgage Arb made a solid contribution. During the month, the US Federal Reserve bought Agency guaranteed bonds outright in order to reduce the spread between the interest rate on FNMA and Freddie bonds and the yield on Treasury bonds. This spread is a key component of the cost of home finance, so it is no surprise to see it targeted, but outright securities purchases from the market do represent an escalation in the battle to reflate the US economy. Our managers have benefitted from the move, but, having seen a similar step when the GSE’s were taken into Government Custodianship, are not yet betting that this is a permanent shift.

One of our Convertible Arb managers lost money; the second was profitable, but not sufficiently to generate an overall profit for the theme. New participants are buying convertible bonds of the best quality while issuers with strong finances are buying their bonds back for cancellation. Bonds of lower credit quality have yet to attract significant interest.

The Merger Arbitrage theme made money. The managers are using very conservative metrics for deciding which trades to enter, but with extraordinary unlevered returns available, there is no need for adventure. For example, the agreed and financed strategic deal for InBev to buy Anheuser Busch closed towards the end of November. Yet just three weeks prior to closing it was possible to enter the trade at an annualised spread of 60%.

There has been no change in the liquidity status of any of our managers since we last reported a month ago, although, as explained above, parts of the Convertible bond market have begun to revive which will help the one small holding in the portfolio that has temporarily suspended redemptions. As always, if you’d like to discuss any aspect of this report in detail, we’d be delighted to do so.

Three of the eight themes in the portfolio made money in the month while the remaining five did not. Of our two holdings in the Credit Spreads in Transition theme, although one was slightly net short in November and the other was definitely long, frustratingly they both lost money. Credit spreads are still trading at outlandish levels, and commentators want to extrapolate the past relationship between spreads and subsequent default rates in order to see what is in store. The alarming results suggest that as IRAX Crossover Index spreads are above 1000bp’s then 50% of the bonds involved will default in the next 5 years, which is a forecast that the world will soon stop turning. A better explanation is that credit markets are not working well enough to offer useful predictions of what is to come. This dysfunction causes frustration and alarm for investors today, but the pick of these mispriced assets will reward their owners richly in due course. We have a number of ideas about how to make the most of this opportunity, but for the moment, the key ingredient is patience.

The Global Financial Sector Dislocation theme appeared here for the first time in October although one of the managers involved was formerly part of the Credit theme as the two themes have a common root. Despite recent casualties, there are still over 10,000 Banks in the US and a large population internationally. None are having a great time, but their circumstances are not identical, and some are doomed while others will survive. Add in the Insurance and Asset Management sectors and it takes meaningful research resources to be able to identify and track the opportunities. Both managers have that strength and the theme produced an excellent result for the month. Japan Corporate Event Opportunities has been one of the most consistent contributors to our returns this year, making money in November also. Dislocation Insurance has been a fourth very effective ‘hedging’ theme during the course of 2008. Our strong results in the theme reflect two things: the identification two years ago of an environment in which multiple dislocations might occur, and the selection of managers who can construct a portfolio which expresses their concerns about the prospects for world GDP growth within a disciplined risk management framework.

Technology Digitisation made a small loss for the month despite the manager’s valiant efforts to protect the portfolio by raising cash and use indices to increase his short. Although we have complete faith in the manager’s skill, we do not believe that the market will allow him the opportunity to make money from small tech companies in the foreseeable future so we have decided to terminate the theme, seeking better opportunities elsewhere.

There has been no change in the liquidity terms of any of our underlying managers since our report a month ago. As always, please calls or e-mail with any questions you may have.

The Culross Global Fund has been awarded ‘Best performing diversified fund of hedge funds over 3 years on risk/return basis’ at the Hedge Fund Review’s 7th Annual European Fund of Hedge Funds Awards held on 26th November 2008.
This is the first year that the same Fund has won more that one category, with the Global Fund also winning the ’1 year’ award.

Nominations

• Winner: Culross Global Fund (Culross Global Management)
• Aurum Aggressive Fund (Aurum Funds)
• The Fitzwilliam Growth Fund (BDO Stoy Hayward Investment Management)
• Claritas G4 Fund – Class Fund of Funds G-7 (Claritas Investments)
• Consulta Alternative Strategy Fund (Consulta)

About the Awards

Hedge Funds Review’s awards are the most sought after accolades in the industry. The hedge fund investment process relies on more than just numbers and our judging process recognises this. Now in it’s 7th year, the European Fund of Hedge Fund Awards remain the only signature event held exclusively for the European fund of hedge fund sector and as such continue to attract the top names from the industry. Chaired by Phil Irvine, Director of PiRho Investment Consulting, the judging panel is impartial and unbiased and seeks to reward genuine performance and success. Previous recipients of these awards have seen as much as a 10 fold increase in their AUM in the 12 months after winning – making the shortlist alone guarantees managers increased awareness in the investor community and an enhanced reputation.

Methodology

The judging process begins by running a screen across all entrants, selecting managers with a significant European presence, typically some investment or due diligence function.

For 1 year awards the period under consideration is July 1st 2005 – June 30th 2008

Each fund of hedge funds is ranked against its peers by its annualised return, its sharpe ratio and its annualised return over its worst month, for the relevant period. These three rankings are added to produce an aggregate ranking and a long-list. Other metrics such as volatility, total return, percentage of positive and negative months and age and size of fund are also generated.

The judges then discuss the various merits of the funds, from both a qualitative and quantitative perspective. Whether groups are of a sound basis and exhibit expert management that could be expected to continue producing, are also taken into account. A shortlist is drawn up, typically of around 5-6 names. From this a winner is chosen.

The Culross Global Fund has been awarded ‘Best performing diversified fund of hedge funds over 1 year on risk/return basis’ at the Hedge Fund Review’s 7th Annual European Fund of Hedge Funds Awards held on 26th November 2008.
This is the first year that the same Fund has won more that one category, with the Global Fund also winning the ’3 year’ award.

Nominations

• Winner: Culross Global Fund (Culross Global Management)
• Aurum Aggressive Fund (Aurum Funds)
• Consulta Alternative Strategy Fund (Consulta)
• Gems Low Volatility Fund (Gems Advisors)
• Liongate Select Fund (Liongate Capital Management)
• Olympia Special Opportunities Class B (Olympia Capital Management)

About the Awards

Hedge Funds Review’s awards are the most sought after accolades in the industry. The hedge fund investment process relies on more than just numbers and our judging process recognises this. Now in it’s 7th year, the European Fund of Hedge Fund Awards remain the only signature event held exclusively for the European fund of hedge fund sector and as such continue to attract the top names from the industry. Chaired by Phil Irvine, Director of PiRho Investment Consulting, the judging panel is impartial and unbiased and seeks to reward genuine performance and success. Previous recipients of these awards have seen as much as a 10 fold increase in their AUM in the 12 months after winning – making the shortlist alone guarantees managers increased awareness in the investor community and an enhanced reputation.

Methodology

The judging process begins by running a screen across all entrants, selecting managers with a significant European presence, typically some investment or due diligence function.

For 1 year awards the period under consideration is July 1st 2005 – June 30th 2008

Each fund of hedge funds is ranked against its peers by its annualised return, its sharpe ratio and its annualised return over its worst month, for the relevant period. These three rankings are added to produce an aggregate ranking and a long-list. Other metrics such as volatility, total return, percentage of positive and negative months and age and size of fund are also generated.

The judges then discuss the various merits of the funds, from both a qualitative and quantitative perspective. Whether groups are of a sound basis and exhibit expert management that could be expected to continue producing, are also taken into account. A shortlist is drawn up, typically of around 5-6 names. From this a winner is chosen.