S&P: Excellent Q1 for funds-of-hedge-funds

Funds-of-hedge-funds rated by Standard & Poor’s Fund Services, the leading provider of qualitative fund management ratings, had an excellent first quarter, all delivering positive returns, says S&P.

The funds-of-hedge-funds that performed best during the quarter were those biased towards equity-related strategies such as special situations, merger arbitrage and long/short equity hedge. These strategies benefited from buoyant merger & acquisition activity around the world.

“Corporate activity has a strong tailwind behind it currently,” said Standard & Poor’s lead analyst Randal Goldsmith, explaining that companies are willing to take on more and more gearing, while investors appear generally relaxed about this, continuing to put money into private equity, which provides further support to leveraged transactions.

Goldsmith noted that although the M& A trend is not as fundamentally based as three years ago, when it was backed by strong balance sheets and low valuations, it now has more momentum behind it. However, he warned: “Equity and related strategies are being well rewarded although there is more risk of confidence suddenly disappearing. On the other hand, credit is tightly priced and exposed to the risks but does not share fully in the upside.”

The star performers in first quarter 2007 were Thames River’s funds-of-hedge-funds, the S&P A-rated Warrior I and II, which returned 6.8% and 8.7% respectively. Manager Ken Kesey-Quick invests the portfolios of these funds primarily in funds run by up and coming managers and is viewed by S&P as one of the best in the business at this particular game.

Although most of the returns for the Warrior funds during the quarter came from special situations managers, one of the most spectacular returns of 28.5% was provided by Paulson Advantage Plus, an event-driven manager applying a short credit strategy in the US sub-prime mortgage sector. This was Warrior I’s largest holding (at 4.5%) and ensured that the fund had a great February when many of its peers were losing money.

Special situations holdings which performed very well for the funds included Rhine Alpha Stars (a Zurich-based long-short equities manager with a focused portfolio of German stocks), Merchant Commodity and Davidson Kempner DO.

Kesey-Quick and co-manager Alex Kuiper are very cautious of credit (which is why they hold Paulson). They are also becoming more concerned over equity market risk on valuation grounds and a belief that there are limits to the share that capital take from companies’ gross profits

Underlying exposure to equities in the Warrior funds is currently around 40% and the managers expect to scale this back to about 30% over the rest of the year. They plan to reinvest into global macro, where they expect the more volatile interest rate environment to provide more opportunities, along with the currency strategy, which is currently small (1.7% of the portfolio) but has been providing good, diversified returns.