Hedge Funds Overcome Tumultuous Fourth Quarter

Hedge funds in Morningstar's database, excluding funds-of-funds, returned an average of 1.98% during the fourth quarter of 2007, outperforming the S&P 500 Index and the MSCI World Index in U.S. dollars.

Hedge funds overcame a tumultuous fourth quarter, and managed to gain 14.13% for the year. The credit crunch intensified in August and November, preventing hedge funds from significantly building on their previous gains.

Emerging-markets equity hedge funds were the clear winners in 2007 with a 32.0% annual return (in U.S. dollars). However, the MSCI Emerging Markets Index outperformed the average hedge fund by more than 4 percentage points for the year. Though emerging-markets hedge funds on average fared better than the index in November, the category did not fully capture the sector's upside in September and October.

With a 16.0% gain, global equity hedge funds were the second-best-performing category, returning about 9 percentage points more than their benchmark, the MSCI World Index. The funds also outperformed the index in the fourth quarter.

U.S. hedge funds fared relatively well. The U.S. equity category posted a modest gain for the quarter with 0.3% but substantially surpassed the S&P 500 Index's returns, both on a quarter- and year-end basis. Even more impressive was the U.S. equity small-cap category, which posted a small gain of 0.8% for the fourth quarter but outperformed the U.S. equity category for the year with 13.6%. Comparatively, the Russell 2000 Index, a small-cap equity benchmark, was down by 1.6% in 2007.

The European and Asian equity category returns sandwiched those of the U.S. equity category. The Europe equity category returned 14.1% for the year after a soft fourth-quarter return of 0.3%, outpacing the MSCI Europe Index for both time periods. The developed Asia equity category ended the year quietly, with a 6.0% return at year-end and a negative 2.0% return at quarter-end. In contrast, short equity hedge funds neared the top of the category charts in the fourth quarter with a 6.2% return, taking advantage of equity market turmoil. Year-end returns for short equity funds reached 7.8%.

Global trend hedge funds, those that systematically follow price trends in futures and currencies, had an annual return of 14.7%. In the fourth quarter, these funds earned 6.5%, more than any other category. Big movements in commodities, such as gold and oil, contributed to these gains. Global non-trend hedge funds saw opportunities to exploit the falling dollar: The category returned 14.9% for the year and 4.3% in the fourth quarter.

Prospects for the corporate actions category dwindled, as credit conditions worsened in the second half of 2007. These funds eked out a 0.3% gain in the fourth quarter and 8.5% for the year. Although declining credit should eventually create opportunities for distressed securities hedge funds, this category's meager results--negative 0.5% at quarter-end and 5.1% at year-end--have yet to reflect any optimism.

No hedge fund category ended the year in the red, but convertible arbitrage hedge funds earned less than U.S. Treasury bills. The convertible arbitrage category performed the worst among all categories, with a negative 2.1% return in the fourth quarter and a 2.4% return for the year. Widening spreads trumped improving convertible issuance and volatility. Debt arbitrage hedge funds were able to manage the widening spreads, with a positive fourth-quarter and yearly return of 1.5% and 12.6%, respectively. Similarly, equity arbitrage hedge funds dealt with stock market volatility deftly, returning 2.9% for the quarter and 12.4% for the year.

Multi-strategy funds underperformed the average single-manager hedge fund, returning 13.4% for the year and 2.9% for the fourth quarter. Funds-of-funds, perhaps affected by their second layer of fees, slightly underperformed multi-strategy funds: These funds returned 13.3% for the year and 2.6% for the quarter.

For more hedge fund data and commentary, visit Morningstar.com's Hedge Fund center.