US hedge funds get defensive in a market where energy rules the roost

US long/short

US equity hedge fund managers have exited a difficult summer into a stream of slightly better economic announcements, although many await election results on 2 November.

Andrew Gibson, managing director at London's International Asset Management, said low volatility and thin volumes affected many equity portfolios over summer.

Old Mutual Asset Management's (OMAM) US Specialist Equity Fund, managed by Terry Ewing and Ann Hall and using a process identifying macro-economic and micro-economic themes before screening for stocks fitting their macro views, primarily in mid-cap equities, was net long in healthcare in mid-September, as well as in other defensives, utilities, industrials and telecoms.

By September, however, healthcare was not uppermost in the co-managers' minds, as the fund added to a long position in basic materials, taking up holdings in AK Steel, Phelps Dodge and Dow Chemical.

"As it became apparent that the anticipated fall in steel prices would be pushed out," says Ewing, "we closed out our short in US Steel. Short positions within basic industries are tending to focus on special situations, which are more exposed to rising energy prices."

Hall added in September, the fund had moved to net neutral in Internet stocks, taking profits after a very strong run. "Overall we're net long of technology although we anticipate that we will add further to the short positions in the coming month."

By sector, the portfolio was overweight basic materials, which the managers felt should benefit from the strong global pricing cycle. The fund was underweight consumer staples, which the managers feel are fully valued and the site of disappointments from a "number of major sector players."

OMAM's managers expected the US equity market to struggle with rising oil prices but do not rule out the possibility it could rally in the final quarter of 2004.

A fourth-quarter spurt could come as a welcome relief, as Gibson notes economic growth around the world "hit a softer patch" in August with July US non-farm payrolls weaker than expected, auto sales down and retail growth slowing. This added to "faltering consumer confidence," according to Gibson, and produced difficult trading conditions for US hedge managers.

In the US, it may have been fixed income managers who had the better season as US Treasury markets rallied on the poorer outlook for stocks. "Despite uneasiness regarding the near-future of the economy," Gibson says, "and a further spike in oil prices, both the investment grade and high-yield bond market enjoyed their strongest month of the year."

Threadneedle's American Crescendo Fund, managed by Michael Corcell, has made money since launch every month bar September on both the long and short sides, and in just four months has returned to investors 9.29% net (dollar class), already well on the way to Corcell's aim of "consistent double-digit returns - net."

"It has been an incredibly turbulent and difficult time managing money," Corcell notes.

Healthcare, producing money for some over summer, suffered aftershocks following US attorney Eliot Spitzer's comments on the insurance industry and Merck's fall, for example, of 30% in barely 10 minutes after the forced removal of one of its drugs from the shelves in late September took the fund down 30bp.

Threadneedle's fund has retained 85%-90% gross exposure across 75 positions, deriving most value from mid-cap holdings but also investing in small and large cap. Now it is positioned for a flat or falling market.

On a macro view, Corcell says: "the US earnings picture does not look great," and the consumer looks "stretched" with much of the mortgage refinancing already completed and few fiscal or tax stimuli left, leading consumer-related stocks to comprise around three quarters of the fund's 40% exposure to shorts.

"Valuations of many consumer stocks are unattractive given the prospects," Corcell says. He has stayed away from troubled airlines in the main, but has made money on a three-month short position in discount carrier JetBlue Airways Corp.

The long book has been largely a story of energy explorers and producers such as Suncorp and XTO Energy. While some could say crude oil has peaked, Corcell says exploration and production costs at around $12/barrel, against sale at $55, still make the firms attractive. And futures five years out at $38 "take a lot of the business pressure off" and improve cash flow for the coming three to five years, as well.

Media firms are among Crescendo's longs of late, with healthy growth and free cash flows. Echo Star Communications and Dex Media are each in the long book.

key points

The healthcare sector has proved a difficult area in many US equity hedge funds' books.

Concern over the market's ability to deal with oil prices has seen US Treasury markets outperform in summer and the third quarter.

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