Review 2009 and outlook 2010

December 2009
Research & Analysis

Thomas Della Casa The team can be contacted at:

Mark Rechsteiner MICH-RASG@maninvestments.com
Ayako Lehmann

• A normalisation of fixed income markets provided the structural

foundations for a very good 2009 for hedge funds. The return of liquidity
together with the huge rally in credit proved the main performance drivers.

• Towards year end, many hedge funds reduced their exposures to risky
assets thus reflecting their overall vigilant view on the macro picture.

• We are also in the cautious camp and remain wary of a number of factors
with the potential to trigger a fresh wave of risk aversion. We favour
managers who are agile, liquid and open-minded going into 2010.

• While there are opportunities in all hedge fund styles, we prefer equity
hedged, global macro and managed futures over event driven and relative
value.

A member of the Man Group www.maninvestments.com

Executive summary

Review 2009
If 2009 had to be summarised in one word it would be normalisation. At the beginning of the year, credit spreads were at extreme levels,
interbank markets impaired, convertible bonds at record cheapness and the whole banking system on shaky ground. All these factors
normalised slowly but steadily throughout the course of 2009 and hedge funds were able to benefit from this trend. In aggregate, hedge
1
funds are up about 13% YTD thereby recouping more than half of the previous year’s losses.

The biggest performance drivers for hedge funds in 2009 were the return of liquidity and increased risk appetite in the entire credit space as
well as equities. Convertible bonds were also a major contributor to many hedge fund returns. Furthermore, managers with an emerging
market focus benefited as did commodity funds. Overall, one can say that managers which lost most last year were the biggest winners
this year. Only a few managed to outperform in both years.

Among the various hedge fund styles, relative value proved the leading light. Massive improvements in liquidity, a rally in credit and broad
normalisation of RV relationships were the main return drivers. Global macro, equity hedged and event driven performed broadly in line with
composite industry returns of above 10%. Managed futures were the clear laggards this year, with CTAs having to contend with
whipsawing markets, particularly in the fixed income arena. With respect to gated, suspended or side-pocketed funds, we observed a
gradual improvement over the course of the year. With some exceptions, most funds were able to lift their restrictions and meet redemption
requests. The de-leveraging process that dominated the hedge fund landscape during 2007 and 2008 has come to an end and in most
styles leverage has increased again, albeit only marginally. As year-end approaches, we are witnessing a general trend towards risk
reduction, with managers keen to consolidate a very good 2009.

Outlook 2010
We are also in the cautious camp and are wary of a number of factors with the potential to trigger a fresh wave of risk aversion. Risky
assets have surged in the past nine months, on the back of increasing hopes of a classic V-shaped recovery. In the aftermath of the
biggest liquidity injection in history, risky assets staged a logical rebound as a wall of money was put back to work. At current levels,
however, equity and credit markets are no longer undervalued. By most standard measurements, both asset classes are roughly in line
with historical averages. Volatility has also receded to its long-term average.

While we do think that the world has improved since March, we remain sceptical of the current valuations of equity and credit markets. A
major headwind facing us over the next few years is the economy-wide unwinding of leverage. Another worry is the removal of fiscal stimuli
that will accentuate in H2 2010 when many stimulus programmes run out. The normalisation of monetary policies which will involve a
cessation of quantitative easing (QE) and possible preparations for interest rate hikes will also be challenging. Further tail risks include a
jump in inflation expectations, a double dip (W-shaped economy similar to 1981/82), a China bubble (liquidity-driven speculation in Chinese
equity and property), protectionism (leading to trade wars) and wide spread (debt)-deflation. Assessing these issues, we believe that
markets will face a very challenging 2010 with frequent shifts in risk appetite.

We favour managers who are agile, liquid and open-minded going into 2010. While there are opportunities in all hedge fund styles, we
prefer equity hedged, global macro and managed futures over event driven and relative value. In equity hedged, we favour managers with
relatively low net long exposures or managers who adjust net exposures quickly. This combination gives us the ability to capture both the
‘risk on’ and ‘risk off’ phenomenon as well as the longer-term trend towards return dispersion. In credit, we maintain a net long exposure.
In addition, we prefer long/short credit managers who can benefit from divergence within corporate credit risks. Our relative value funds
should have exposure to strategies that benefit from rising volatility. Finally, we like the flexibility of the macro managers as well as the
liquidity of the CTA universe. Overall, we think that hedge funds are well positioned to profit from shifts in risk appetite and directional
moves in currencies, interest rates, bonds, commodities and equities.

1
As at 30 November 2009.

Review 2009 and outlook 2010 2 / 18

Review 2009
General market overview
The gloom continued until
the beginning of March…
…when markets reversed
180 degrees and staged a
powerful rally
A sea of liquidity and
increasing risk appetite
propelled markets
continuously higher
Review 2009 and outlook 2010
The first nine weeks of 2009 were essentially a continuation of H2 2008. Global equity
markets continued their downward spiral and financial institutions were desperately
trying to raise capital to stay afloat. In many cases, only national governments were
willing and able to inject new equity into these ailing firms, aiming vigorously to avoid
another high-profile collapse on the scale of Lehman Brothers. It became increasingly
evident that the world economy would not see a quick snap back to pre-crisis activity.
Moreover, emerging market nations, which previously proved to be rather resilient, also
capitulated in the face of falling external demand with obvious implications for global
trade and market sentiment.
This gloomy course of events came to an abrupt reversal at the beginning of March
when Citigroup announced positive news regarding its profitability for Q1. During the
following three weeks, the S&P 500 rallied 21%, the most extreme rebound witnessed
since 1938. The rally continued into May and market participants became increasingly
convinced that the worst, i.e. a total collapse of the banking system, had been avoided.
While the overall economy still produced mostly negative news flow, forward looking
indicators such as consumer confidence began to recover from very low levels. Markets
also started to factor in the benefits from the vast fiscal stimulus packages. China’s
huge expansion of bank lending to fund infrastructure investments and raw material
stockpiling gave a boost to commodity prices. Moreover, systemic risk for emerging
markets was reduced at the G20 summit in London when the IMF was given more
resources to provide credit lines to countries in need. All these steps improved investor
confidence and risk appetite, along with prices, steadily rose.
After a few weeks of sideways trading during summer, markets received another boost
in mid-July when the Q2 reporting season turned out better than expected. Market
participants became increasingly confident that a large number of companies would be
able to quickly adjust their cost base and, in many cases, maintain their margins.
Moreover, a lot of corporate entities were able to raise new capital and refinance/
restructure their debts to maintain some flexibility. In addition, the markets also
benefited from a sea of liquidity that demanded to be put back to work. With zero-
interest rates in money markets and bank accounts, many money managers were
forced to re-enter the markets and hunt for yield. As seen on the next figure, money
market funds reached record highs at the end of 2008 as investors fled to risk-free
assets. During 2009, this ‘money mountain’ was slowly reduced, but is currently still
above average. At the beginning of 2009, some money flowed into credit: first into
investment grade bonds and slowly up the risk/return curve into high yield and
convertible bonds. As confidence broadened, capital flows were directed towards
equities, emerging markets and other risky assets, often in conjunction with a ‘buy-the-
dips’ strategy.
3 / 18
 Figure 1: US money market funds were re-invested into risky assets
50

45

40

35

30

25

20 Average
15

% 10

2001 2002 2003 2004 2005 2006 2007 2008 2009

Retail and institutional money market funds as % of market cap

Source: DataStream and Credit Suisse as at 14 September 2009.

‘Risk-on’ versus ‘risk-off’
and high correlation
dominated 2009
In essence, the negative feedback loop that dominated H2 2008 and the beginning of
2009 has turned positive for the last eight months, with success breeding success. This
reflects the ‘risk on’, ‘risk off’ trade that prevailed throughout 2009. ‘Risk off’ dominated
in Q1 and came back for a short period over the summer and again at the end of
October. This was evident in the form of equity and commodity markets trending lower
in conjunction with a widening of credit spreads, USD appreciation and declining
government bond yields. ‘Risk on’, which was the trade for most of 2009, is the
opposite of that outlined above. This ‘correlation of everything’ has increased risks for
certain investment disciplines (i.e. multistrategy) as normal diversification among sub-
strategies has been low.

Hedge fund performance YTD

If 2009 had to be summarised in one word it would be normalisation. At the beginning

Normalisation of liquidity
and credit benefited hedge
funds
of the year, credit spreads were at extreme levels, interbank markets impaired,
convertible bonds at record cheapness and the whole banking system on shaky
ground. All these factors normalised slowly but steadily throughout the course of 2009
and hedge funds were able to benefit from this trend. In aggregate, hedge funds are up
2
about 13% YTD thereby recouping more than half of the previous year’s losses.

2
As at 30 November 2009.

Review 2009 and outlook 2010 4 / 18

 Figure 2: Hedge fund performance 2009
3.5 % 112

3.0 % 110
2.5 %
108
2.0 %
106
1.5 %
Monthly return USD 104
1.0 %

Index value USD

0.5 % 102

0.0 % 100

-0.5 % 98
09

09

09

09

09

09

09

09

09

09
r0

g
ay

ov
ar
n

ct
Ju
Ap
Fe

Au

Se
Ja

Ju

O
M

N
M
Monthly return HFRX Global Hedge Fund Index (LHS)
Index value HFRX Global Hedge Fund Index (RHS)

Source: Hedge Fund Research, Inc. Time period analysed: 1 January to 30 November 2009.

The biggest performance driver for hedge funds in 2009 was credit, which actually
2009 saw a huge reversal in 3
bottomed three months prior to equities in late 2008. While investing in credit made a
4
lot of sense at the beginning of 2009, the stellar returns of 49.88% for high yield bonds
fortunes… 5
and 41.08% for leveraged loans nonetheless far exceeded even the most optimistic
expectations. Convertible bonds, powered by the massive credit rally, were also a major
6
performance driver for many hedge funds. Furthermore, managers with an emerging
market focus benefited as did commodity funds. Overall, one can say that managers
which lost most last year were the biggest winners this year. Only a few managed to
outperform in both years.

Among the various hedge fund styles, relative value proved the leading light. Massive
…relative value proved the improvements in liquidity, a rally in credit and broad normalisation of RV relationships
were the main return drivers. Global macro, equity hedged and event driven performed
most profitable strategy broadly in line with composite industry returns of above 10%. Managed futures were the
clear laggards this year, with CTAs having to contend with whipsawing markets,
while managed futures particularly in the fixed income arena. With respect to gated, suspended or side-
pocketed funds, we observed a gradual improvement over the course of the year. With
underperformed some exceptions, most funds were able to lift their restrictions and meet redemption
requests. The de-leveraging process that dominated the hedge fund landscape during
2007 and 2008 has come to an end and in most styles leverage has increased again,
albeit only marginally. As year-end approaches, we are witnessing a general trend
towards risk reduction, with managers keen to consolidate a very good 2009.

3
Credit markets (high yield bonds) bottomed on 11 December 2008, roughly three months prior to equities which bottomed on 9 March 2009.
4
CS High Yield Index 1 January 2009 to 30 November 2009.
5
CS Leveraged Loan Index 1 January 2009 to 30 November 2009.
6
ML Global Convertible Bond Index (G300) is up 34.83% YTD (from 1 January to 30 November).

Review 2009 and outlook 2010 5 / 18

Figure 3: Hedge fund themes and trading ideas in 2009

Style Themes and trading ideas in 2009 Did it work?

Yes during Q1 but then short positions were covered as

Short financials
markets reversed
Not in H1 as first all stocks fell and then ‘bad stocks’ rallied
Equity hedged Dispersion (long ‘good stocks’ short ‘bad stocks’) strongly. Effective to some degree in H2 as markets were
more fundamentally driven
Long consumer staples, short consumer This only worked at the beginning of the year when
discretionary defensive stocks outperformed
Convertible bond arbitrage Performed extremely well, just the opposite of 2008
Steepeners worked well until May, then the trade lost
Fixed income arbitrage: Yield curve plays
momentum
Fixed income arbitrage: tactical trading around Worked well as record new supply of government papers hit
auctions the markets
Relative value
Yes as incoming liquidity closed the gaps between CDS and
CDS basis trade
cash bonds
No. Most quant funds and market neutral funds
Market neutral equity
disappointed this year
Long volatility No, as volatility came down throughout the year.
Little M&A activity but the few deals that occurred were
Merger arbitrage
highly profitable.
Event driven
Worked well for those with unimpaired books and few
Long distressed
hedges
Negative on the USD Did not work as well as the media headlines indicated
Long emerging market FX, FI and Equity Yes
Global macro
Commodities Not a big performance driver for macro managers
G7 FX No
Long equity indices Yes, except in Q1
Managed futures Long fixed income No. Big loser for CTAs this year
Long commodities Did not generate significant performance due to ‘roll’ losses
Source: Man Investments Research.

Equity hedged performed in line with expectations. The HFRX Equity Hedge Index
Equity hedged fared well gained 13.32%. 7 This compares to 19.21% for the MSCI World (hedged to USD) and
18.57% for the MSCI World in local currencies. Emerging markets recorded a stellar
considering the low net long 8
71.72% (in USD). Consequently, managers with long EM equity exposures
outperformed those that allocate only to the US and Europe. Fundamental managers
exposures struggled at times as the environment was often macro and liquidity driven. Net long
9
exposures were kept low throughout the year, ranging from 10% to 30%. Looking at
these figures, considering the low net long exposure, equity hedged served its purpose
well.

We think 2009 can be divided into three different time periods. In the first period
Until March short books (January to March) stocks continued their downward spiral and cyclical as well as
financial stocks underperformed defensive names. During this period, equity hedged
made a lot of money… managers did a very good job by protecting the downside. They even made money

7
YTD from 1 January to 30 November 2009.
8
All MSCI figures are YTD (1 January to 30 November 2009).
9
Estimate Man Investments. Lowest value (10%) was at the beginning of the year, before increasing toward 30% and currently about 25%. Figures refer to US and Europe only.

Review 2009 and outlook 2010 6 / 18

 while long only indices suffered double-digit losses. This was mainly achieved with short
positions in financials and consumer discretionary businesses.

The second period can be referred to as ‘dash for trash’ or ‘from depression to
…but underperformed recession’ (April to June). During this phase, equity markets rose strongly and the lower
quality stocks (typically capital intensive, deep cyclical stocks with low margins and
during the initial phase of debt-loaded) hugely outperformed higher quality stocks, i.e. defensives. During this
period, equity hedged managers underperformed and did not participate in the rally due
the rebound… to their low net exposure and quality tilt. Short positions in financials were either closed
or shifted into intra-sector dispersion plays (e.g. short regional banks, long large cap
banks).

The third period started in mid-July (still ongoing), when markets began to price in the
…until rising dispersion macro recovery and better-than-expected corporate profits due to cost cuts. During
this time, value outperformed growth and cyclicals outperformed defensives. Stock
became evident dispersion was higher than in the previous two periods. Managers slightly increased
their exposures (both net and gross) and thus benefited from the rising tide. The typical
move of the markets was two steps forward and one step back as buyers pursued a
‘buy-the-dips’ strategy.

Relative value funds benefited significantly from renewed confidence in the financial
Relative value benefited system and the improved liquidity. By our estimates, about 70-90% of RV assets can
now be classified as liquid, considerably more than the 50% witnessed at the beginning
significantly from the return 10
of the year. Put in a nutshell, 2009 can be described as the year that was liquid and
irrational versus 2008 which was illiquid and irrational. The zero-interest rate policies
of liquidity (ZIRP) that were introduced and maintained by major central banks together with
11
quantitative easing (QE) clearly promoted higher liquidity across all asset classes.
While the term QE can be applied broadly to the concept of non-traditional monetary
policy in a ZIRP environment, the Fed also refers to the term credit easing, which
essentially aims to reduce credit spreads for corporations and home owners to facilitate
re-financing. The rise in financial stability could be observed in a number of factors,
such as a lower TED spread, which reached pre-crisis levels during summer, lower
MBS and ABS as well as CDS spreads across the board, falling volatility across all
asset classes and reduced cheapness in convertible bonds.

Another component of the RV spectrum which performed well was convertible bond
Convertible bond arbitrage arbitrage. Convertibles benefited from significant cross-over buying at the beginning of
the year and subsequently from the massive rally in credit and the general return of
was a major performance liquidity. Prime brokerage financing also improved steadily as banks returned to
normality. Convertible bond arbitrage is the best example of the complete reversal in
driver… trading conditions: while in 2008 everything went wrong, in 2009 everything went right.
12
The HFRX Convertible Arbitrage gained 39.17%. In fixed income arbitrage, managers
benefited from yield curve steepeners during H1 as the US yield curve reached record
steepness in May (276 bps). European yield curves also steepened, but not quite as

10
Man Investments estimates
11
Structured credit instruments such as CDOs as well as ABS or CMBS are still rather illiquid
12
Hedge Fund Research, Inc. Index return 1 January to 30 November 2009

Review 2009 and outlook 2010 7 / 18


…as was fixed income
arbitrage
Equity market neutral and
long-biased volatility funds
struggled
Distressed managers with
intact portfolios benefited
from the strong credit rally
13
Down from 46 in 1980 and 31 in the 1990s.
Review 2009 and outlook 2010
much. This steepening occurred on the back of a normalisation of inflation expectations
at the long end of the curve.
Throughout the year, managers profited from tactical trades around new issuance, with
a huge supply of sovereign debt very much in evidence (shown in next figure). Some
fixed income managers even proclaimed a ‘golden age’ for the strategy as a lot of
competing funds have folded and there are currently only 18 primary dealers for USTs.
13
Typical trades were tightly hedged butterflies ahead of a large auction, followed by a
quick unwinding immediately afterwards.
Figure 4: Net sovereign debt issuance in mature markets (in billion USD)
3500
Japan
3000 United Kingdom
Euro area
2500
United States
2000
1500
1000
500
0
2002–07 2008 2009 2010
Average actual Actual Projection Projection
Source: IMF estimate, IMF Global Financial Stability Report, October 2009. Numbers are converted to US dollars
at current exchange rates. Net issuance includes bonds and bills.
Not all RV buckets did well. Market neutral equity strategists, quantitative traders (quant
funds) and volatility-oriented managers all experienced difficulties. For quant funds, the
main problem this year has been the prevalence of positive serial correlation. In July, for
example, the FTSE registered 11 consecutive daily gains, a pattern which has only been
seen twice since 1985. As a consequence, mean-reversion based models failed to
function effectively at a time when investors had already become disillusioned with
quant strategies following two years of sub-par returns. Volatility focused funds tend to
be long volatility and a backdrop characterised by polarised markets proved an
unsupportive environment for such a strategy.
Distressed managers’ returns were highly dispersed. Those with impaired portfolios
from last year’s turmoil struggled as they were effectively forced to liquidate holdings at
low prices. Conversely, managers with sufficient liquidity to stay afloat or even add
exposures during late 2008 and early 2009 benefited from the huge rally in distressed
securities. Credit as an asset class performed extremely well, outperforming equities
and other risky assets by a wide margin. High yield bonds gained 49.88% and
8 / 18
 leveraged loans were up 41.08%. 14 Much of this rally was due to continuous capital
inflows into high yield mutual funds, rather than being attributable to fundamental credit
valuation. While defaults rose strongly until summer, they stabilised somewhat in the last
few months of 2009 and have either peaked already or should do so very soon.
Currently, the default rates stand at 10.96% for high yield bonds and 13.90% for
15
leveraged loans. The most high-profile defaults this year were Lyondell, Charter
Communication, General Motors, Chrysler and CIT Group. All of these defaults
presented opportunities to hedge funds, which profited either by trading the securities
passively or taking an active involvement in Chapter 11 restructurings. Moreover, GMAC
(which did not default) was also a widely held name as it traded well below 70 cents on
the dollar for an extended period.

Special situations managers benefited from a few highly profitable transactions. While
Merger activity was low but the overall M&A volume was low, there were a handful of large deals that allowed
managers to lock in gains. Since a lot of money has left the merger arbitrage
the few available deals were community, and with less competition following the decimation of banks’ trading desks,
spreads did not close as fast as in previous years. One example of a very profitable
hugely profitable M&A deal was Pfizer’s acquisition of Wyeth. On 26 January 2009 Pfizer made a USD 68
billion bid to purchase its rival to form the largest pharmaceutical company in the world.
Until its close on 15 October, the spread only closed slowly (as pictured on the next
chart), despite the relative ease of the transaction. This is one example where the
diminished prop desk and overall smaller hedge fund and merger arbitrage community
clearly help to enhance returns for the ‘survivors’. Other interesting deals were the Pepsi
Americas / Pepsi Bottling Group transaction, Oracle’s bid for Sun Microsystems or the
ongoing battle for Cadbury by Kraft.

Figure 5: Narrowing of the Wyeth/Pfizer spread during 2009

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5
Spread in USD

1.0

0.5
Wyeth/ Pfizer merger spread
0.0
Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09

Source: Bloomberg. Time period analysed: 27 January to 15 October 2009. Spread is calculated as follows:
USD 33 + (0.985*PFE) – WYE. Deal closed on 15 October 2009.

14
CS High Yield Index and CS Leveraged Loan Index. 1 January to 30 November 2009
15
JPMorgan par-weighted default rate, excludes distressed exchanges. As at 31 October 2009.

Review 2009 and outlook 2010 9 / 18

 Global macro delivered very solid returns in 2009. The largest drivers of performance
Global macro managers were long positions in EM sovereign credit and FX, tactical longs in equities, trades in
G7 fixed income, and short USD positions. Commodity trading was not as active as in
focused on tactical trading previous years and dedicated currency funds delivered disappointing results. Market
conditions did not allow for longer term themes and concentrated portfolios. Instead,
most global macro funds focused on short-term tactical trading in order to maintain
flexibility and liquidity. Managers kept their options open and traded multiple asset
classes in multiple regions regardless of market direction.

Perhaps the turning point of 2009 was the recovery of emerging markets that followed
Biggest gains came from the G20 summit in London in April. The IMF made clear in this meeting that EM
countries would get access to credit required to cope with the crisis, essentially
fixed income and FX… removing the threat of sovereign default for heavily strained economies such as Latvia,
Hungary or Ukraine. This ‘IMF floor’ changed the market psychology and led to a multi-
month rally in risky assets, particularly equities and sovereign credit.

It is commonly perceived that the EM world handled the most recent crisis much better
…as EM economies are than in previous market cycles and that the real danger of further economic and
systemic weakness lay in over-indebted G7 countries. For many seasoned EM investors
recovering faster than the this was a new situation. It seems that the painful history of previous crises such as
16
currency devaluation, hyperinflation, capital flight etc had the benefit of forcing
developed world increased fiscal discipline and improved current account balances. Because of this, the
17
majority of EM countries were able to engage in anti-cyclical policy steps , i.e. allowing
their currency to weaken as they reduced monetary policy rates and as a result were
the first to see improvements in their economies.

18
While the classic de-coupling theory was rejected by most macro managers (and
economists alike) there was a majority opinion that the EM world would recover faster
than most over-leveraged and indebted developed countries. This view turned out to be
correct as emerging Asia and most of Latin America showed expanding industrial
production numbers as well as increased business activity overall. Eastern Europe has
been the laggard as large countries such as Russia, Ukraine, Romania and the Baltics
remain in deep recessions. Global macro managers benefited from this by being long
equities, sovereign credit and FX in countries such as Brazil, Mexico, Korea and Turkey.
These trades played out nicely as the currencies rose while the credit spreads narrowed
19
(see next figure). Brazil was a major driver of performance in both FX gains (30%) and
sovereign CDS (-280 bps). 20

16
In the past, most financial crises originated in emerging markets, e.g. Turkey (2001), Argentina (2001), Russia (1998), Brazil (1999), just to name a few.
17
Such anti-cyclical steps include traditional monetary policy (lower interest rates), government spending increase through fiscal stimulus (e.g. various stimulus packages) or even
tax rebates (e.g. Brazil reduced taxes on new car purchases)
18
The classic de-coupling theory suggests that emerging markets’ business cycles move independently to major developed economies in the US, Western Europe and Japan.
19
Brazil, Mexico and Turkey all have large liquid sovereign debt markets whereas many countries in emerging Asia and Eastern Europe lack liquid markets
20
1 March to 17 November 2009

Review 2009 and outlook 2010 10 / 18

 Figure 6: EM sovereign credit spreads narrowed while their currencies appreciated
140 BRL
MNX
500 TRY
130 BRAZIL CDS USD SR 5Y Corp
MEX CDS USD SR 5Y Corp
TURKEY CDS USD SR 5Y Corp
120
400

EM currency rebased against USD

110

100 300

CDS spreads (in bps)

90

200
80

70
100
Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09

Source: Bloomberg. Time period analysed: 1 January to 17 November 2009.

In stark contrast to profitable long EM currency positions, the classic G7 FX traders

G7 FX produced produced disappointing returns. While there have been some opportunities in some
commodity-based currencies such as the ABCs (Australia, Brazil and Canada), most
disappointing results other trades lost money. The short USD theme was highly anticipated in early 2009, but
was somehow missed by many traders, as for most of the year the dollar’s decline has
only been slow and gradual. By the time the greenback accelerated its decline at the
beginning of September, many funds had already exited the trade or rolled shorts to the
Euro or Yen. Moreover, implied volatility in FX declined over the course of the year,
leading to time decay (theta) losses on positions expressed through long options.

Commodities enjoyed a strong year. While prices rallied for many commodities, steep
Commodities benefited from contangos significantly reduced returns for long-only investors. The S&P GSCI (spot)
rose 46.85%, while the total return index (including roll returns and interest rates)
the weak USD and Chinese 21
produced a much more modest gain of 12.51%. The big performance driver for
commodities was the weak dollar (strong negative correlation) and strong Asian
stockpiling demand for commodities in H1. The headline grabbers on the long side were sugar and
22
cocoa. While sugar doubled in a relatively short time during the summer , cocoa
reached thirty year highs. Strong performers during 2009 included base metals, which
benefited from Chinese stockpiling. The energy complex was very diverse with crude oil
rising strongly and natural gas declining for most of the year. This divergence highlights
one of the differences in the dynamics of oil and gas pricing. While oil is a global
commodity, gas remains somewhat regionalised and less prone to macro conditions
such as the weakening dollar. Due to low demand in G7 countries, gas prices remained
depressed while oil benefited from strong EM demand and more notably, the
weakening dollar. Commodity hedge funds performed well, but did not add as much
value as during 2008 when they protected the downside extremely effectively. For
further details, please refer to our recent paper called: ‘Facts and myths about
23
commodities – October 2009’.

21
As at 30 November 2009
22
Mainly due to poor yields in India and Brazil
23
Report is available on the maninvestments.com website: https://www.maninvestments.com/alternative_investments/research.jhtml

Review 2009 and outlook 2010 11 / 18

 Managed futures traders clearly got a reality check after a stellar 2008. YTD returns for
Managed futures suffered most CTAs are shallowly negative. The CS/Tremont Blue Chip Managed Futures Index
24
is down 0.73%. The main reason for this year’s disappointing performance came from
from whipsawing bond a lack of trends in the bond markets (see next figure). Going into 2009, CTAs were
heavily tilted toward the ‘recession trade’, i.e. long bonds, short equities, short
markets commodities and long USD. These positions did not work well when long-term interest
rates normalised and equities rebounded. Over the summer and into September and
mid-October, CTAs were able to recoup some of the losses, mainly due to long
positions in equity indices and short USD (e.g. versus AUD). However, during the last
week of October this burst of good performance was erased when markets reversed.
YTD neither commodities nor currencies have achieved a positive performance
attribution to the overall CTA performance, with only stocks contributing positively.
Overall, many markets were characterised by whipsaws and rapid reversals which is
always a problem for CTAs. The next figure shows the problems of the whipsawing
bond markets illustrated with the German government bonds.

Figure 7: 10-year German government bond yields whipsawed in 2009

3.8 %

3.7 %

3.6 %

3.5 %

3.4 %

3.3 %

3.2 %

3.1 %

3.0 %

2.9 %
Yield

Euro Generic Government bond yield 10 yrs

2.8 %

Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09

Source: Bloomberg. Time period analysed: 1 January to 10 November 2009.

24
CS/Tremont (YTD 2009 until 30 November 2009)

Review 2009 and outlook 2010 12 / 18

Figure 8: Performance table 2009
Performance indicators (as at 30 November 2009):
Hedge Funds YTD Equities YTD
HFRX Global Hedge Fund Index 12.77% MSCI World Index (hedged to USD) 19.21%
HFRX Equity Hedge Index 13.32% MSCI World Index (LC) 18.57%
HFRX Relative Value Arbitrage Index 34.67% MSCI Emerging Markets 71.72%
HFRX Event Driven Index 15.40% S&P 500 21.30%
HFRX Macro Index -6.32% DJSTOXX 600 20.57%
CS/Tremont Blue Chip Managed Futures Index -0.73% TOPIX -2.25%

Fixed income Commodities

Citigroup World Government Bond Index (hedged to
2.02% S&P GSCI (Total Return) 12.51%
USD)
JPM Emerging Market Bond Index (global composite) 27.77% DJ UBS Commodity Index (Total Return) 16.60%
CS High Yield Index 49.88% Crude oil (WTI) 73.27%
Source: Bloomberg. Time period analysed: 1 January 2009 to 30 November 2009. Please note that the HFRX Macro Index contains several managed futures managers.
Therefore, the index is not a good representative for global macro managers. Nevertheless, we included this index in the interest of completeness.

Outlook 2010
General market outlook

We are in the cautious camp and remain wary of a number of factors with the potential
We are in the cautious to trigger a fresh wave of risk aversion. Risky assets have surged in the past nine
months, on the back of increasing hopes of a classic V-shaped recovery. In the
camp aftermath of the biggest liquidity injection in modern history, risky assets staged a
logical rebound as a wall of money was put back to work. At current levels, however,
equity and credit markets are no longer undervalued. By most standard measurements,
both asset classes are roughly in line with historical averages. Volatility has also receded
to its long-term average and systemic risks (i.e. a major bank failure) are now less of a
concern.

While we do think that the environment has improved since March, we remain sceptical
Consumer de-leveraging of the current valuations of equity and credit markets. A major headwind facing us over
the next few years is the economy-wide unwinding of leverage. In the US, for example,
has just begun consumer debt is currently at 128% of disposable income. The average over the last 50
25
years has been 79%. Even if consumer debt remains above average, this still means
that there will be trillions of dollars of lost consumption in the US, with potentially
26
deflationary effects. Another worry is the removal of fiscal stimuli, with many stimulus
programmes scheduled to end in H2 2010. It will be difficult for governments to extend
27
stimuli as screaming budget deficits must be reduced at some point.

25
Ned Davis Research
26
Some call this the new normal, the frugal future or the seven lean years, etc.
27
This is of course a catch 22 situation for policy makers: if they remove fiscal stimulus prematurely, the economy will double dip and if they extend it the market may force bond
yields higher as debt-to-GDP ratios reach critical levels.

Review 2009 and outlook 2010 13 / 18


Where is the exit please?
Source: Standard Chartered Global focus, 4 Nov. 09.
Another challenge will be the normalisation of monetary policies regarding the QE exit
and possible preparations for interest rate hikes. This is perhaps the biggest macro risk
for 2010 as central banks will be facing a dilemma of having to maintain ‘exceptionally
low rates’ given the still very fragile economy, but with the danger of an increasing
disconnect between risky asset valuations and the economy. We think that tightening
policies do not need to be synchronised. Australia, Norway and Israel have already
hiked rates while the Fed, the ECB and the BoE as well as BOJ have not signalled any
such moves. In our opinion, this reflects the dichotomy within the macro outlook. Some
economies will close their output gaps relatively quickly and return to sustainable
growth paths while others will take much longer. We are of the opinion that the US,
Europe and Japan face an extended road to recovery and hence will keep rates lower
28
for longer. The next figure illustrates this scenario.

Figure 9: The larger the output gap, the longer away the exit
7

Japan
6 UK

US
5
EU
Mexico
4
Russia
New Zealand
Estimated output gap (in %)

3
Brazil Thailand
Norway
Sweden
2 Canada
Taiwan
India
1 Australia Indonesia

0
0 2 4 6 8 10 12 14 16 18 20
Time to exit from stimulus policies (months )

12

Source: Societe General. Output gap refers to the difference between potential and actual GDP growth rates.
Slightly modified by Man Investments Research.

Other tail risks include a jump in inflation expectation, perhaps due to a massive surge
Various tail risks remain in commodity prices, a double dip (W-shaped economy similar to 1981/82), a China
bubble (liquidity-driven speculation in Chinese equity and property), protectionism
(leading to trade wars) and wide spread (debt)-deflation. Assessing these issues, we
believe that markets will face a very challenging 2010 with frequent shifts in risk
appetite. In terms of priority for risky assets we prefer to be long credit over long equity
from a risk/return perspective.

28
On average, the Fed has raised rates 19 months after the peak in the unemployment rate, during the recession after WWII, according to Credit Suisse.

Review 2009 and outlook 2010 14 / 18

Outlook for hedge funds
We favour managers who
are agile, liquid and open-
minded
Equity hedged is well
positioned to benefit from a
fundamentally driven market
Our allocation to relative
value has been lowered
Credit dispersion and long-
biased volatility offer
opportunities
Review 2009 and outlook 2010
Overall, we favour managers who are agile, liquid and open-minded as we believe it is
not the time to be complacent or stubborn in directional views. In equity hedged, we
prefer managers with relatively low net long exposures or managers who adjust net
exposures quickly. This stance should provide us with the ability to capture both the
‘risk on’ and ‘risk off’ phenomenon as well as the longer-term trend towards return
dispersion. In credit, we maintain a net long exposure. In addition, we prefer long/short
credit managers who can benefit from divergence within corporate credit risks. Our
relative value funds should have exposure to strategies that benefit from rising volatility.
Finally we like the flexibility of the macro managers as well as the liquidity of the CTA
universe. Both styles should be able to capture trends in fixed income, currencies and
commodities.
We believe that equity hedged managers will be in a good position in 2010 as the wide
dispersion regarding the global recovery favours the approach utilised by many
long/short funds. With current valuations and various factors (e.g. small caps versus
large caps, value versus growth) at their long-term averages, equity markets will be
increasingly driven by fundamentals and less by fear and greed. On the long side,
managers should benefit from stocks with an international growth angle and those
companies that are well positioned to take market share from rivals. On the short side,
managers should be able to identify companies that will struggle in the post ‘easy-
credit’ world. The best environment for managers would be a material outperformance
of the former stocks over the latter while indices go nowhere. Less favourable scenarios
include an extended bull market, which would favour long-only strategies, and/or
another severe sell-off, which could trigger renewed government intervention.
Our allocation to relative value has been markedly lowered. In spite of a record year for
a number of RV managers, this reduction reflects the business and liquidity issues still
prevalent. Moreover, we do not envisage the current performance to continue at such a
rapid pace. Convertible bond arbitrageurs, for example, have performed excellently this
year but the beta juice has been pressed out to a large degree. While managers can still
make money, we think it will be harder to achieve above-average returns.
A main theme within RV will be credit dispersion where managers aim to profit from
increasing or decreasing corporate credit risks. It is expected that credit quality will
improve for some companies and deteriorate for others as many business models have
to be re-designed (e.g. companies that rely on debt-financed consumer spending like
retailers, leisure travel or gaming). On the long side of the spectrum are cash-rich
companies that will benefit from the crisis through increased market shares. In
sovereign fixed income, there will still be a number of tactical opportunities, e.g. at
auctions of new government papers. Another RV theme will be the long-biased volatility
strategy geared towards benefiting from event risk by being long optionality and
convexity.
15 / 18
 Our preference for liquid styles leads to an underweight in event driven. Nevertheless, in
Distressed opportunities are terms of strategies, we prefer distressed over special situations. We think that there are
plenty of opportunities in distressed despite this year’s rally in non-investment grade
still abundant… credit. Both 2010 and 2011 will bring a number of interesting opportunities in bank and
corporate restructurings, bankruptcy reorganisations, leveraged loans, distressed
mortgages, commercial mortgages and some outright short plays. The dollar amount of
potentially distressed opportunities including mortgages is estimated to be as high as
29 30
USD 6 trillion. Just in distressed mortgages, there are still 17,000 AAA rated MBS.
Looking at the maturity profiles of leveraged loans, it is notable that the bulk becomes
…as a lot of companies
due in 2013 and 2014 as seen in the following figure. This is partially due to the fact that
pushed out maturities a number of stressed companies have avoided defaulting on their debt by pushing out
near-term maturities through various types of transactions. Hence fewer companies
have defaulted this year than previously anticipated, and fewer will do so next year.
However, the debt maturing in later years will have to be restructured at some point as
very few companies can refinance through operating cash flows. Many of these
restructurings will present attractive opportunities for distressed managers.

Figure 10: Bulk of high yield bonds and leveraged loans mature in 2013/14
USD 3000 High-Yield Bonds

4
7.
26
Leveraged Loans

USD 2500

USD 2000
0
5.
16

.8
1
14
USD 1500

0
USD

0.
5
4.

12
11
.7
1

7
10

.
97
.9

.9
USD 1000
82

82
.5
72
.9
64

.9

.5
42
.8

38

USD 500
32

.0
23
3.
8

13
7
9.

8.

0
0.

0.
USD 0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Debt Maturing (USD bn)

Source: JPMorgan. Note: Data for leveraged loans does not include revolvers.

Global macro managers will continue to focus on liquidity, flexibility and tactical trading
Global macro managers in 2010. There are several trading themes that will drive performance. Volatile currency
and interest rate markets should present good opportunities and remain the asset
continue to believe in classes of choice for global traders due to the wide opportunity set and liquidity. The
improvement in liquidity in emerging markets and increasing fundamental differences
emerging markets’ between EM and G7 countries should also be a significant return driver. Overall, the
view is that EM will continue to outperform developed markets. Emerging Asia and Latin
outperformance America are generally favoured over Eastern Europe due to their lower debt levels and
improved economic competitiveness. GM managers tend to be long EM assets across
the board, but are aware of the fact that the significant rally seen in 2009 could lead to
some type of retracement in 2010. They are also mostly bullish on commodity
currencies, such as AUD and CAD. The short USD theme will remain popular so long as
the US pursues an accommodative monetary policy and aggressive fiscal stimulus.
However, it is acknowledged by hedge fund managers that the trade is seen as

29
Paulson, Credit Suisse, Dr. Edward Altman-NYU Salomon Centre
30
Man Investments Research

Review 2009 and outlook 2010 16 / 18

 increasingly crowded. While the overall sentiment is still bearish on the USD, some
managers are getting ready to exit or reverse their positions.

With respect to the inflation/deflation debate, the majority opinion is that inflation will not
No big bets yet on central be an issue until 2011 and beyond. However, views vary and are largely dependent on
the timing and magnitude of change to monetary and fiscal stimulus in 2010. The ECB
banks’ exit strategies… is thought to hike rates first, followed by the BoE. The US and Japan have the largest
output gaps and thus appear set to keep rates lower for longer as inflation and
employment growth are likely to remain subdued.

What themes or opportunities could drive performance in 2010? While markets and
…but there are other economists alike do not anticipate a quick exit from the Zero Interest Rate Policy (ZIRP)
anytime soon (i.e. don’t fight the Fed), some managers are considering trades that
opportunities on the radar express a contrarian view. If investors are caught by surprise, fixed income and foreign
exchange markets would certainly react strongly. There is also a risk of a major spike in
bond yields, should demand for sovereign government bonds diminish. Japan could
potentially face massive re-financing problems due to its declining savings rates. JGB
31
steepeners are set to profit from this in the long term.

Commodities should remain supported as long as risk appetite remains high and the
The case for commodities US dollar weak. However, current price levels are conditional on a sustained economic
recovery in 2010. In case of a double dip, prices would likely decline heavily. In any
remains intact as long as case, commodity hedge funds have shown their ability to manage their exposures and
are poised to be vigilant to any signs of economic weaknesses. Managers are cognizant
the global recovery of the money flows into the long-only ETFs and will manage around the rebalancing of
the major indices in January.
continues
In natural gas, the view remains cautious as current storage levels are very high and
production is still robust as a result of recent shale plays. The oil complex is marked by
over-supply in Western countries while EM countries are expected to take up some of
the slack. Additionally, OPEC is believed to have spare capacity, making price shocks
to the upside unlikely. In the soft space, the sugar trade has been scaled back, while
cocoa remains supported with production in key growing regions, such as the Ivory
Coast, continuing to decline. China demand seems poised to remain a key feature as
infrastructure build-up continues in 2010.

Managed futures will depend on the emergence and persistence of trends. We continue
Managed futures are set to to have a high conviction that CTAs have good prospects to benefit from moves in
numerous asset classes. Such moves could include a bond crash (pre-mature ZIRP exit
benefit from moves in the from major central banks) and/or an inflation scare (commodity prices shoot through the
roof). For short-term traders, an expansion of volatility should prove favourable. The
various asset classes strong liquidity profile and excellent risk-return characteristics are also key attributes.

31
This is not a widely played theme. However, one manager made the following comment: JGBs are like subprime staring you in the face in 2006

Review 2009 and outlook 2010 17 / 18

Important information

This document includes facts, views and opinions of global economic markets deemed of interest. In preparing this publication, we have relied upon and assumed, without
independent verification, the accuracy and completeness of all information available from public sources or which was provided to us or otherwise reviewed by us. Man
Investments believes its data and text services to be reliable, but accuracy is not warranted or guaranteed. We do not assume any liability in the case of incorrectly reported or
incomplete information. This material is proprietary information of Man Investments and its affiliates and may not be reproduced or otherwise disseminated in whole or in part
without prior written consent from Man Investments.

Alternative investments can involve significant risks and the value of an investment may go down as well as up.

Some statements contained in these materials concerning goals, strategies, outlook or other non-historical matters may be “forward-looking statements” and are based on current
indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and Man Investments undertakes no obligation to update or
revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those
contained in the statements.

Review 2009 and outlook 2010 18 / 18