The Culross Global Fund has been awarded ‘Best performing diversified fund of hedge funds over 10 years’ at the Hedge Fund Review’s 9th Annual European Fund of Hedge Funds Awards held on 24th November 2010. Culross Funds have received HFR awards for 4 consecutive years. You can view the Winners and the Fund’s profile at the HFR site.

The Culross Global Fund has been awarded ‘Best performing diversified fund of hedge funds over 3 years’ at the Hedge Fund Review’s 9th Annual European Fund of Hedge Funds Awards held on 24th November 2010. This is the third year running that the Fund has won the 3 year award. You can view the Winners and the Fund’s profile at the HFR site.

The portfolio put in a robust performance in April. Credit Spreads in Transition (20% of NAV), Energy Market Opportunities (11.4% of NAV) and Japan (4.2% of NAV) all did well. No themes lost money.

However, the market mood has changed dramatically since the beginning of May. The Euro area liquidity fix, agreed on Sunday May 9th was of sufficient size to create an atmosphere of ‘shock and awe’ in financial markets. Military jargon is appropriate to this saga because, in tha aftermath of the Greek refinancing crisis, we are now in a budget deficit reduction ‘arms race’ where fiscally challenged Governments feel that they must enforce greater and greater stringency in order to keep the ‘bond market vigilantes’ at bay. Where will it end? This depends on two things; the capacity of the Club Med countries to craft and implement credible plans to adjust their economies, and on the willingness of their populations to accept the pain of these adjustments in order to repay lenders in full.

By agreeing to intervene in debt markets, the ECB has surrendered its independence. Even if it sterilises the monetary impact of these purchases, the Central Bank will end up as a major creditor of the PIIGS. If, or more likely, when there is a subsequent debt restructuring, the loss will be socialised and the impact on private sector institutions reduced. The ECB’s ownership is spread among the EU’s 27 members pro rata by GDP. But losses (and profits) are the responsibility of the Euro area’s 16 members.

Apart from having a completely inappropriate name, the ’1997 Stability and Growth Pact’ which ushered in the Euro era was part of an entirely misconceived operational framework. The lack of an adjustment mechanism was supposed to be a discipline to force member countries to stick to the rules. But this failed to allow for the possibility that states with limited respect for rules would simply ignore them. They could borrow at the same rates as sound credits, while both markets and their Euro area fellows overlooked the weakness of their public finances. No regulatory mechanism operated, either official or commercial. The Germans meantime, were busy managing the politics of trade deficits. They succeeded in promoting the idea that deficits were sinful and surpluses virtuous, making their own economy more competitive as their neighbours slowly priced themselves out of the game. At this point, winning the game looks like being almost as painful as losing., though at least Euro weakness will help exporters.

Our Relative Sovereign Opportunities theme produced a modest gain in April. It first appeared in the portfolio in April 2009. and events are playing out along the lines envisaged in our thematic analysis. Although the theme results are positive, they are frustratingly modest.

At the end of the first week of May, we reported that widespread financial market stress was reflected in an estimated 1% fall in the value of the Fund. At the end of the second week of the month the number is closer to 1.25% but it is important to note that this estimate is based on incomplete information, as our managers do not report uniformly intra month.

In a month of strong returns, five of the nine themes in the portfolio contributed the bulk of the result. At the manager level, over 75% of our 34 funds made money. There were no loss-making themes.

US Treasury bonds fell during the month as yields rose from 3.61% to 3.84% in 10yr maturities. But this did not stop High Yield bond funds receiving inflows of $1.8bn in March, reversing an outflow of more than $1bn in February. Investment Grade spreads tightened, so did High Yield spreads, but indices of defaulted securities rose much more, racking up a 13th straight positive month in the case of the NYU Stern indicies. This positive momentum was visible in Europe and Asia as well. Credit Spreads in Transition was the top performing theme in the portfolio.

While Greece hogs the headlines, there are significant shifts in Government policy taking place elsewhere. During March, Australian rates rose another 25bps, making a rise of 100bps since October. Malaysia became the first emerging Asian jurisdiction in which rates rose; India followed soon after. The posture of Central Banks in Canada, Sweden and Switzerland also changed. We do not expect the major developed economies to raise rates now nor in the near future. Neither do we regard the Greek liquidity fix as a cure for the solvency problems faced by Southern European borrowers. However, the pattern of widely differing economic performance across countries and between regions is now clearly visible. Our Relative Sovereign Opportunities managers are running increasingly diversified range of attractive and profitable positions as a result. Four out of five of them made money in March.

Our Energy Market Opportunities theme was the third largest contributor to March returns. Crude oil broke out of the $70-80 range in which it had been stuck. This move was accompanied by a fall in volatility and, less surprisingly, by a decline in inventories both in the crude market and in certain refined products. It was also significant that oil rose against a background of dollar strength. The optionality built into the fund of our oil trading manager benefitted from these developments. The equity specialists in the theme had a mixed month. Japan Corporate Event Opportunities and Inflation/Deflation Uncertainty both generated profits.

Global Financial Sector Dislocation had a neutral impact on the month’s results. However, it became clear during March that we should reduce the population of managers in the theme from three to two. The impact of fundamental credit issues on the valuation of Bank stocks has systematically weakened through recent months. It is a perfectly logical expedient for the FDIC to broker deals for the absorption of failing Banks into less vulnerable neighbours. However, the timing of these moves and their impact on the valuation of the securities of the institutions involved makes for a treacherous investment environment. We have submitted redemption notice for the fund in the portfolio that remains exposed to small and midsized US Banks.

February was a month in which both manager and theme returns were tightly clustered. The power of fiscal stimulus policies and GDP growth to act as the dominant drivers of markets, is diminished. But the timing, mechanics and consequences of the exit are not yet clear enough to have taken over.

Three themes made a contribution of 10bp or more. All the managers in Credit Spreads in Transition made money, despite a slight widening of spreads. Energy Market Opportunities and Inflation/Deflation Uncertainty were also profitable. A senior IMF economist (named Blanchard as it happens), produced a paper arguing that recent Central Bank Inflation fighting practice has been misconceived. He thinks that setting a 2% inflation target is like asking a pilot to fly so close to the ground, that any error has dire consequences. Better to aim a little higher, say 4%, and allow more latitude for the imprecision of economic policy making. It will be some time before we can see the impact of this, but the article offers a first building block in the construction for the case for looser inflation policies.

Governments have largely socialised the debt excesses of the ‘Great Moderation’. According to Credit Suisse, the net issuance of debt by the governments of the US, Japan, Europe and the UK in the years 2002-7 amounted to $1t in total. In 2009 net issuance was $3.25t, but Governments, through their Central Banks, bought a big chunk of this themselves. In 2010 $2,25t of net new money is to be raised. Against this background, the creditworthiness of governments cannot escape scrutiny. But that does not mean that hedge funds are about to perform a repeat of George Soros famous 1992 coup in hounding Sterling out of the European Exchange Rate Mechanism. In fact, round 1 has been won by the politicians. The threat of regulation of naked Sovereign CDS trading (well, regulation of buying protection anyhow) has rendered that market toothless, and the Greeks have persuaded capital markets to continue providing them with support for now.

This interim victory does not address the fundamental flaws in the Euro construct. The treaties creating the euro deliberately exclude a bail out methodology and there is no institutional framework to provide remedial support to struggling economies. The politics of such support will not work without the threat of worse to come, in other words a rescue plan will only sell in a crisis. We do not know whether the sternest test will come now, as the weak Euro countries ramp up borrowing, or later, if the forecast success of today’s rescue policies fails to materialise. But it does not seem likely that current spread relationships reflect what is in store. In the month, Relative Sovereign Opportunities was the worst performing theme, costing the portfolio 15 basis points.

The Japan and Financial Sector themes also made small losses, while the remainder of the portfolio had no significant impact.

By the end of January, asset markets began to reflect doubts about Sovereign credit and concerns over tightening policy. So our Relative Sovereign Opportunities thesis is being played out in the headlines. The co-ordinated nature of the stimulus measures introduced to counter the financial crisis in 2008/9 magnified its benefit. However, stimulus withdrawal cannot be synchronised. Not only do growth rates vary between countries, but so do borrowing requirements, average debt maturities, the tax base and a number of other metrics. Credit spreads, interest rates, yield curves and currency values can be expected to reflect the perceived variations in national and regional performance for as long as those differences grow. The theme made money.

All seven holdings in Credit Spreads in Transition were profitable. The post crisis tightening of credit spreads is over. Last month’s letter described the broad range of exposures reflected in the market coverage of our current manager line up. We are confident that they will have plenty to do.

Global Financial Sector Dislocation made a positive contribution in January. It is a theme with a defensive dimension. Circumstances have been created that support big bank profitability despite limp loan growth and stubborn credit losses. We believe that the banks and insurers still face wrenching change and that our specialist managers can get ahead of the market in recognising its impact.

The fourth contributor to January’s result was our energy theme. The energy industry is global, yet many of its participants are listed on national equity markets where local valuation drivers overshadow the wider picture and thus create anomalies which our Energy Market Opportunities managers are out to capture. In addition, energy pricing is a major macro input and a key agent for change in financial market valuations. Recognising its significance, on February 1st, we added an energy trading manager to the mix.

Our remaining themes did not have a material impact on January’s results. Below is a brief update on the rationale for three of them.
Our longstanding Asian Consumer Power theme reflects the view that its fundamental strengths will continue to show through in higher rates of growth than elsewhere, and that local consumption will account for a rising share of GDP, providing further impetus to the trend.

Japan Corporate Event Opportunities is made up of three managers with an aggregate weighting of 4% of the portfolio. Our largest manager is seeking opportunities arising out of the widespread international neglect of Japanese equity investments avoiding market direction. His fellows are deep value equity specialists with strong defensive skills. Their perspective will help us track of developments. Think of this as a low cost, long dated, option on future Japanese success.

Given the political temptation to allow it to reduce the future value of today’s government borrowings, inflation is the threat over the horizon. Our Inflation/Deflation Uncertainty theme is made up of two elements; a fixed income specialist with a high level of expertise in real return bonds and an equity manager whose stock selection process includes a robust test of the impact of inflation.

In December, two thirds of the managers in the portfolio made gains. At the theme level, three material positive contributions accounted for the bulk of the return. One of our nine themes detracted, and then by less than 20bps.

All along the credit curve, spread compression was a big story in 2009.In High Yield, spreads fell by two thirds. This year will not see a rerun, but a different set of appealing opportunities is showing through. The distressed cycle is at or near its peak, weighty refinancing schedules loom over the market and deleveraging is a continuing priority for man. Credit Spreads in Transition is weighted at 19% in January. The manager line-up now covers Asia in depth, as well as the US and Europe. It covers corporate securities, financial sector paper and some US Residential Mortgage backed bonds. With the addition of the newly created Culross Long Term Alpha Fund, it incorporates some exposure to stressed and distressed securities, especially in the US. One by-product of the boom in structured credit is that the tool kit available to specialist credit managers is much wider than it was. Spread relationships between cash bonds, indices and CDS are a simple example of the opportunities that can be accessed in corporate credit today. Managers now have flexibility over the precise net exposures they choose to run. Prior to the crisis, the skills and systems required to make a success of investing in the anomalies that arise in this environment were not found outside the Investment Banks. Not only is this is no longer the case, but the banks do not have the capital to act as they might wish.

December’s profitable theme return in Relative Sovereign Opportunities was a composite of three positive and two negative manager results. Although the Fund made money in this theme in 2009, it has been frustrating to see this pattern recur during the year and cost us a proportion of the opportunities available. However, the story is not over. Greece has drawn attention to the changes taking place in the old order of creditworthiness. Record prospective public sector deficits are a big problem and, at the very least, will reduce the potential for western economies to grow. In those geographies in which growth does show through, markets face the withdrawal of the fiscal and monetary stimulus that produced the good news. Will this be well handled and skilfully timed; will it be co-ordinated? Meanwhile, Asia has resumed its growth path, unconstrained by significant personal or public sector debt. Our view is that there will be sharp regional and national differences in the post crunch consequences of loose policy. These differences will drive the behaviour of exchange rates, interest rates and sovereign credit spreads as well as equity markets. Our theme is designed to focus on this and carries a weighting of 8% from January 1st.

The third contributor to the December result was Japan Corporate Event Opportunities. We will be down to three managers here by the end of January. Their emphasis is on short term anomalies rather than the macro outlook.

The Culross Global Fund has been awarded ‘Best performing diversified fund of hedge funds over 3 years’ at the Hedge Fund Review’s 8th Annual European Fund of Hedge Funds Awards held on 26th November 2009. This is the second year running that the Fund has won the 3 year award.

The Global Fund also achieved a Highly Commended nomination in the ‘best performing diversified FoHF over 1 year’ category. You can view the Fund’s profile at the HFR site.

The Culross Global Fund and the Culross H Fund have received awards as a top ranked Fund of Funds based on its 3 year performance by Portfolio Adviser magazine.

Methodology

Using data from Morningstar – a database of over 4,000 Fund of Funds, Portfolio Adviser took the top 10 ranked Funds and presented them to the judging panel.

The judges were then asked to nominate 3 Funds where they would invest their own money as well as that of their clients if investing today. Portfolio Adviser collated these results, awarding one Winner and 2 Highly Commended.

• The Culross Global Fund was announced as the overall winner.
• The Culross H Fund received a highly commended.

Since the dark days of the first quarter, financial markets have been propelled on a rapid recovery path by massive fiscal and monetary stimulus. The risk of the failure of the financial system has been brought under control and, in most cases, GDP declines have been arrested. Critically, US GDP grew at an annualised 3.5% in Q3.

In the face of two Australian and one Norwegian rate rises, October was the month in which financial markets began to look beyond stimulus and ask – what next? Will this recovery be like those we have seen before? In our view, it will not. The IMF estimates that outstanding Government borrowings in the G20 will be 118% of GDP by 2014. There is wide dispersion in the fiscal standing of G20 countries, but these are record peacetime numbers and represent a major challenge. To get back to 80% will require a combination of tax increases and spending cuts in the order of 6.7% of GDP over 10 years; 8% for a return to pre crisis debt levels at 60% of GDP. Who is going to vote for that? If they are sustained, large budget deficits put upward pressure on rates, reduce private investment and depress living standards.

Then there is the monetary stimulus. Although widely deployed it is most obvious in the US and UK where, through their use of QE, Governments own bonds worth 12-15% of GDP. This manoeuvre was designed to fend off deflation by relaxing monetary policy. Once victory is declared in that battle, these holdings will need to be sold in addition to the new bonds required to fund the deficit and refinance maturities. There is no precedent for the smooth timely withdrawal of monetary stimulus on this scale. Yet markets are pricing perfect policy execution.

The themes that make up our portfolios reflect the view that a rapid return to coordinated global growth, in an environment of low inflation and steady asset markets, is not the most likely outcome. In fact we think it is inconceivable. It is too simplistic to describe the present position as ‘a boom in Asia and a liquidity driven bubble in the West’ but regional differences in economic prospects are obvious from a comparison of government finances, and regional growth differentials can be expected to widen. Within regions, national policy and differences in its implementation will be revealed under the scrutiny of the vigilantes of the foreign exchange and bond markets. The same volatility in the macro variables will also make an impact at the sector and corporate level.

Theme results for the month were quite tightly grouped, four were positive, four negative and one was neutral. All the managers in the Credit Spreads in Transition theme made money. But there were managers on both sides of the profitability divide in all the other themes. Turning points are only ever identifiable in hindsight, but within these manager results are indicators of some very odd valuation swings reminiscent of past sea changes in market behaviour.