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.

It is tempting fate to draw attention to such things, but April was the 18th consecutive positive month in the recent performance record of the Arbitrage Fund, an unbroken run that began in November 2008.

There has been a shift in the pattern of the contributions we see from our themes over that period. Given the scale of the change in the investment environment that has taken place in the meantime, this is hardly surprising. Further change is imminent, but not necessarily unhelpful. As we have pointed out previously, legislation to restrict the proprietary trading activities of the US Banks will also limit bank participation in arbitrage. As this report is written in mid May, the US Congress appears to be on the point of enacting such measures.

As in March, Merger Arbitrage produced the best performance, despite widening spreads, particularly on deals in the oil sector. There was a healthy list of strategic acquisitions announced in April such as HP‘s bid for Palm, Hertz’s approach to Dollar/Thrifty, and Shell’s bid for Arrow Energy. Financial buyers are back in the game too: Interactive Data Corporation, CKE Restaurants and Skillsoft have agreed to bids from Private Equity buyers backed by the Banks and Novell is the subject of an approach. This reflects the normalisation of the markets for High Yield and Bank debt, especially in the US, and stands to increase deal activity to a marked extent.

All four of our Fixed Income Arb managers were profitable. Given that the trend in volatility in fixed income reversed sharply in late April, this was a good outcome. Renewed concerns about European Sovereign debt became sufficiently intense that money market and short term interest rate spreads began to widen once more, much as they had done in 2008. The package of measures agreed between the Euro members on May 9th contained measures that will suppress this pressure. But the volatility jolt involved will throw up some interesting relative value opportunities.

The Mortgage Arb theme had a positive month, led by the return from the manager added this month. This fund was added to the portfolio partly as a result of his demonstrable trading skill, which has enabled him to make a strong initial contribution in a month in which Agency Mortgage markets were range bound.

Instrument Arbitrage had a neutral month and Volatility Arbitrage recorded a small loss. However, May has witnessed a sharp reversal in volatility across the board as the news of European structural weakness has brought a measure of dislocation and anxiety to financial markets. After the first two weeks of the month, the net impact of this on the Arbitrage portfolio is negative to the extent of just under 1%.

All six active themes made money in April, but Credit Spreads in Transition (35% of NAV), Asian Consumer Power (12.4% of NAV) and Energy Market Opportunities (8% of NAV) contributed the lion’s share.

Events in Europe have exerted a pronounced influence on financial markets everywhere since the end of April and created a degree of dislocation in the process. The May 9th Euro area liquidity fix was of sufficient size to startle market participants, but many of the details relating to its implementation have yet to be clarified. Neither are the deficit reduction plans announced in Spain and Portugal entirely clear in their scope. The final outcome of this story depends not only on the capacity of the Club Med countries to adjust their economies but also 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 weak sovereign borrowers. If, or more likely, when one of them is forced to restructure, the loss will be borne by the Euro bloc and the impact on private sector institutions reduced.

Relative Sovereign Opportunities produced a gain in April even though three of our four managers had small losses. The theme first appeared in the portfolio in April 2009. Events are playing out along the lines envisaged in our thematic analysis then, as sovereign credit and currency markets occupy centre stage. Yet, although the theme results are positive, they are frustratingly modest.

Both managers in Energy Market Opportunities made money. Oil rose to a 19 month peak in $ terms in early May but has since slipped back in line with the general weakness in commodity prices. The loss of life and the environmental impact of the accident in the Gulf of Mexico have been well documented, but its likely influence on future oil production is a bigger story. Recent discoveries have either been in politically challenging geographies or in deep water. Inhibitions on the development of these fields will further underpin future real energy prices.

Of our Asian Consumer Power managers, one nimbly took his profits in April on his Chinese bank and property stocks. A second sees enticing opportunities in consumer goods stocks as prices retreat. Current Chinese policy initiatives represent another chapter in the story of engineered growth by sector and by region. This time, less developed inland regions are favoured over coastal areas, and the construction of smaller cheaper homes is favoured over higher end projects. Equity market deflation is a side benefit. To adherents of the philosophy of the ‘invisible hand’, growth manipulation policies may appear unsatisfactory. But the key point is that for policy makers in China, a miss on the upside is much less dangerous than an unplanned slowdown.

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.

Five of our six themes were profitable in March, producing a strong overall result.

Merger & Event Arbitrage generated the best return. All four Fixed Income Arbitrage managers made money. Despite the traumas suffered by both Greek Bond investors and Greek citizens as they watch the EU rescue wrangle conclude, volatility in Government Bonds declined further. This is not to say that opportunity declined as there was money to be made from the continuing normalisation of price relationships across the volatility surface. March was the first month in which new US Treasury issuance was absorbed by a market free of influence from the QE programme. Whether this was the reason or not, participants report reduced appetite for new bonds and an increase in pricing concessions on new issues in order to encourage their absorption. This translates into wider spreads on the simplest form of the classic fixed income arb trade. In recent quarters, one of the four managers in the theme has lagged its peers systematically, and we have therefore redeemed this holding. There is no shortage of talent in the field.

Mortgage rates rose, but by slightly less than US Treasury yields, which suited the tilt in the optionality incorporated in one of our managers portfolios, but both of our Mortgage Arbitrage managers were profitable. Our second manager spent the month rebuilding his portfolio following the accelerated buyout of delinquent Freddie Mac bonds in February. In this theme too, we have initiated a manager change, adding a firm with a demonstrable trading aptitude.

Our Instrument Arbitrage manager finds markets particularly interesting when there is a marked change in the flow of investments into or out of the Asian region. Flows to Emerging Markets from the west have stepped up in recent weeks. Increasingly frantic media speculation about the prospect and timing of a possible change in China’s currency management programme has added further spice. Events elsewhere in the region have also produced anomalies in short term market reaction to Toyota’s recalls, the prospect of large scale capital raising by China’s big Banks, a disruptive earthquake in Taiwan and an unexplained explosion on a South Korean naval ship which killed 40 crew members. Convertible Arbitrage generated a small positive return.

Our Volatility Arbitrage manager lost money during this first month of his inclusion in the portfolio, although the impact was tempered by the limited 2% allocation. Equity market vol declined in the face of broad rises in the indices, fixed income vol fell as previously discussed and foreign exchange markets quietened down as anticipation of a move in the RMB grew.

We have added an additional Merger & Event Driven Arbitrage manager. This fund embraces complexity, but without surrendering liquidity and adopts an extremely thorough approach to the construction of its trades and to the diversification of its portfolio. We expect it to consider opportunities right across the market capitalisation range and to have wide geographic coverage.

Five out of seven themes made money in March.

The spread on the Merrill Lynch US HY index tightened from 660bps over to 585bps over, while High Yield bond funds received inflows of $1.8bn in March. Investment grade bond spreads are back to the levels last seen in November 2007. In the first quarter, indices of defaulted US bonds and loans are up 25% and 8% respectively. Credit Spreads in Transition was the top performing theme in the portfolio.

Net investment flows into the Asian region in the first quarter are estimated to have totalled $10bn, compared with a bit over $50bn for the whole of 2009. Yet the contribution that the Asian Consumer Power theme made in March was driven by favourable news at the operating level in many companies held by the funds involved. It is encouraging that the managers report a continuing flow of new stock ideas at attractive valuations.

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 had its best result in some months.

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 manufacturing and service economies to raise rates now or in the near future, but natural resource based countries are experiencing different pressures and must adjust policy accordingly. Traditional relationships between commodity demand, inventories and prices are weaker today than they have been historically. This may reflect new demand patterns, the increasing influence of the financial investor or something completely different. But it represents another potential source of volatility in the macro picture. Relative Sovereign Opportunities made money in the month and we added a fourth manager at the beginning of April so increasing the theme weighting to 22.25%.

Global Financial Sector Dislocation lost money. We have submitted redemption notices for two of the three managers in the theme. In one case, this followed a change in key personnel. The second fund has maintained an exposure to small and midsized US Banks expecting weakness in their loan books to be reflected in stock price weakness. 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 is hard to forecast and shareholders often get a premium for their co-operation. This makes for a treacherous and unappealing investment environment for a manager with a short bias.

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.

Three of the larger themes in the portfolio contributed small gains in February. Their collective 70% weighting meant that these gains substantially outweighed the small loses made by the remainder.

Merger Arbitrage had a good month. Schlumberger bid for Smith, Air Products for Airgas, Merck bought Millipore, Coke bought Coke bottlers and the Xerox and Burlington Northern transactions closed. The pace of activity is rising. All three Convertible Arb managers made money, even though the environment was not particularly helpful in that credit spreads widened while volatility declined. Convertibles have become a stock pickers market once more.

Merger Arbitrage had a good month. Schlumberger bid for Smith, Air Products for Airgas, Merck bought Millipore, Coke bought Coke bottlers and the Xerox and Burlington Northern transactions closed. The pace of activity is rising. All three Convertible Arb managers made money, even though the environment was not particularly helpful in that credit spreads widened while volatility declined. Convertibles have become a stock pickers market once more.

Mortgage Arbitrage was a slight drag on the fund’s performance. As highlighted a month ago, an accounting change led two of the US Governments Mortgage Agencies to accelerate their buy out of damaged loans. Because of their high coupons, the bonds called in this process were typically trading above par, so unwary holders took a knock on the news. In addition to the direct losses, this created some dislocation, risk aversion and spread widening in certain mortgage bonds, which temporarily exaggerated the direct effect. A part, in fact the larger part, of the QE programme was executed by means of Fed purchases of mortgage bonds. This buying will formally end on March 31st although there is no indication that the Fed will sell any of its holdings in the foreseeable future: the exertion of downward pressure on mortgage costs remains a key policy goal. Obligingly, markets are pricing overall Agency Mortgage Bond spreads at historic lows.

We have redeemed our sole Multi-Strat Diversified Arbitrage manager. We remain convinced of his skills, but his fund lost a dominant client, raising its expense ratio above the threshold of acceptability.

In February, we added one manager to seed a Volatility Arbitrage theme with an initial 2% weighting. The environment in which Arb specialists operate continues to be benign. But the co-ordinated reflation policies brought to bear on the 2008/9 crisis are now generating uncoordinated recoveries with highly differentiated asset market consequences. The resulting pressures on sovereign credit, interest rates, foreign exchange and equity markets will throw up anomalies not just in the prices of these assets, but in the markets that trade the volatility of those prices as well.

At the theme level, a solid positive return in February came from Credit Spreads in Transition, where our five managers each produced gains for the second month in succession, but in more challenging conditions. Credit markets reversed direction in mid February and High Yield Mutual Funds saw net outflows. The volatility of daily returns in High Yield has climbed fourfold since December. In the US, $300bn of securities at face value has been purged from the sector by restructurings and bankruptcies since the start of 2008, compared with $125bn at the peak of the last default cycle in 2001/2. But returns in the past year exceed those from the start of the last decade. So we may well have arrived at the point where the credit pickers prevail, getting paid for their ability to master the more awkward propositions.

Energy Market Opportunities produced a tiny gain while the Asian Consumer Power theme was neutral. Much effort is being expended on the selection of the letter of the alphabet that best describes the profile of the recovery commentators hope that the Global Economy is going to experience. Rather than a ‘U’ or a ‘W’, those positive on Asia are forecasting a ‘K’. The upstroke of the K depicts the trajectory that Asian growth will take. The down stroke reflects the outlook for the rest of us. In the event that there is no one to export to, Asian economies will need to make continuing adjustments to the balance of their economies and the role of domestic consumption will need to expand. But there is still a case for the ‘K’. The Government elected last year in India presented its first budget during February. India does not have the same reliance on exports as some of its regional neighbours, but it does have fiscal challenges, reflected in a projected 5.5% Budget deficit/GDP ratio. It also needs to continue structural reforms. Both priorities were reflected in the proposals tabled.

Two themes held the performance back. The weighting allocated to Global Financial Sector Dislocation is in the course of being reduced by a quarter and the number of managers reduced to two. In 2009, 140 US Banks closed; 20 more have closed this year and there are over 700 on the FDIC list of institutions at risk. Yet continuing weakness in the fundamental picture is not reflected in the valuation of bank stocks as the financials continue to outperform broader stock indices.

The role of politics in markets grew during February, but it did so without specific proposals for additional regulation. Talk of Sovereign CDS bans has alarmed participants to the point where, for the time being, the market in Greek risk has ceased to function as a liquid market. US Taxpayers might well ask why banning these instruments was not considered before they spent $170bn bailing out AIG, one of the leading actors in the CDS drama. The managers in the Relative Sovereign Opportunities theme produced mixed results individually, but a small loss in aggregate.

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.