1Q 2012 Quarterly Commentary

Capital Markets Review

As a reminder to how quickly market perceptions can change, we reviewed our third quarter commentary from last year.  What a difference 6 months can make!   U.S. stocks produced their strongest start to a year since 1998 as investors gained confidence from a perceived “solution” to Europe’s debt troubles as well as continued strengthening of U.S. and global economies. In addition, stock markets around the world rallied for very similar reasons.  The continued stimulus from central banks, together with the relative calm in the face of Greece’s debt default (let’s call it what it is) pushed investors into the proverbial “risk-on” trade that benefitted small cap stocks and high yield bonds.  As investors became more confident in the U.S. and global economies, growth stocks trumped value stocks in performance.  In the U.S., among the large cap stocks, financials, information technology and consumer discretionary sectors led the way with telecom and energy stocks lagging.  Globally, almost all major markets experienced the same type of exuberance as the U.S. with Japan and Germany leading the way among major markets and the UK and Spain lagging. 

 

U.S. treasuries suffered the worst quarter in almost two years as investors piled into riskier assets and the underlying current of continued fiscal deficits sparked further flows into high yield and junk bond funds.  Investors scaled back their holdings of low-yielding government debt, which was the safe haven of last year’s second and third quarters.  Consistent with market action and our comments, European debt rallied strongly in the first quarter and high yield, lower credit fixed income rallied strongly across the globe.  Emerging market debt performed well as investors liked the dual aspect of higher yields and solid fiscal and trade balances in select countries.

 

Hedge Fund Industry Review

Overall, broad hedge fund indices produced solid, yet unspectacular returns versus equities, as these diversified strategies had stronger relative returns in January and February and were relatively flat in March.  The HFRX Equity Hedge Index returned 3.9%, a very solid return in a non-volatile, consistently upward market, considering that we believe macroeconomic issues remain key drivers  in today’s market.  Returns for event driven strategies and relative value strategies were also good as hedge fund managers took advantage of market inefficiencies and reasonable spreads in lower quality fixed income securities.  Most macro strategies lagged as managed futures performed poorly.

 

Returns of long/short equity managers were quite good, in general, as many managers were able to adjust net exposures during the quarter as the markets continued to rebound on the heels of solid Q4 2011 performance.  Despite maintaining lower net exposures, hedge funds were able to perform well as dispersion among equity security returns increased from the low levels seen in  2011.  Equity managers appear prepared for sideways markets from here (consolidation) or a potential decline as issues in Europe, a slowdown in China and continued fiscal concerns in the U.S. could arise to the forefront quickly and cause a sell-off.

 

Fixed income strategies continue to be an area of strong relative performance versus investment grade government and corporate bonds and an area we believe where opportunities are robust enough to benefit from actively managed strategies.  Certain strategies could also work well in a rising interest rate environment which isn’t necessarily around the corner, but could begin to occur in the next 12-24 months if the U.S. economy continues to grow at a slow pace and fiscal irresponsibility does not abate.

 

Review of Hatteras Alpha Hedged Strategies Fund’s Performance

For the quarter, the Hatteras Alpha Hedged Strategies Fund (“ALPIX”, “Alpha”) performed in-line with general hedge fund benchmarks, lagged the strong results of equities and outperformed the high grade bond index.  Alpha’s first quarter return was 3.4% versus 3.4% for the HFRI Fund of Funds Composite Index, 12.6% for the S&P 500 TR Index, and 0.3% for the Barclays Capital U.S. Aggregate Bond Index.  Almost all strategies produced comparable returns for the quarter ranging between 3.7% and 4.4%, except managed futures which produced an almost 1% loss. 

 

Long/Short Equity*
Allocation:  34%
Strategic Range:  25%-45%

The long/short equity strategy continued to be an area of relative strength for Alpha, gaining 4.5% in the quarter versus a return of 3.9% for the HFRX Equity Hedge Index and 12.6% for the S&P 500 TR Index.  Consistent with the competing tail wind of an improving U.S. economy versus the macroeconomic/political headwinds of Europe, China, the Middle East and U.S. deficits, we saw a wide range of returns among our different sub-strategies within the strategy.   Managers continued to increase net exposures after Q4 of last year and finished the first quarter with a 36% net long exposure compared to 32% at the end of last quarter. 

We would anticipate net exposures to decrease in the coming months to reflect a defensive posture in light of the market rally and uncertainty regarding domestic corporate earnings. The two largest sector exposures at the end of the month on a net basis were health care and information technology.  

We ended the quarter with a 34% allocation to long/short equity, approximately the mid-range of our allocation band.

 

Market Neutral*
Allocation:  14%
Strategic Range:  5%-25%

On a relative basis, market neutral was the strongest performing strategy for the fund in Q1, gaining 3.7% versus a return of -1.6% for the HFRX EH: Equity Market Neutral Index.  All managers had a strong first quarter, benefiting from strong stock picking as well as lower correlations and increased dispersion among equity returns.  Specifically, exposure to technology led the strategy with energy and basic materials also contributing. Quantitative momentum was also a positive contributor during the quarter despite lower volatility in equity markets. We believe the strategy remains poised to benefit in an uncertain market environment that could become more of a stock-picker’s market.

 

Relative Value- Long/Short Debt*
Allocation:  23%
Strategic Range:  10%-30%

This strategy produced a 4.2% return, versus a 3.3% return for the HFRXRV: Fixed Income Corporate Index, 0.3% for the Barclays Capital U.S. Aggregate Bond Index, and 5.2% for the Merrill Lynch High Yield Master II Index.  The performance was strong, benefiting from exposure to emerging market debt and lower quality fixed income exposure in the U.S., leveraged loans, convertibles,  and residential mortgage backed-securities.    Spreads on these securities were healthy, just above long term averages, yet the outlook for defaults remains relatively benign with a moderate U.S. economic recovery and vastly improved corporate balance sheets since the dark days of 2008/2009.  Managers continue to view the high yield market as attractive but are also continuing to find opportunities in bank loans and capital structure arbitrage.  

 

Event Driven*
Allocation:  19%
Strategic Range:  10%-30%

While this strategy produced the second highest return of all strategies with 4.3% in Q1, it lagged the HFRX Event Driven Index which recorded a 5.8% return.  Overall ‘events’ remained limited across larger cap companies, but continue to present niche managers with opportunities in the middle market. Exposure to event-driven cyclical names was a key driver for performance during the quarter while merger arbitrage was additive, but muted deal flow hampered returns. While the environment and conditions remain ripe for more deal activity, confidence on the part of corporate management teams will be the key to increased deal flow in the coming months. Meanwhile, managers continue to find niche opportunities in the middle market which should continue to drive returns.

Managed Futures*
Allocation:  9%
Strategic Range:  0%-20%

Although the managed futures strategy finished the quarter down -0.9%, the strategy significantly outperformed the HFRX Macro-Systematic Diversified CTA Index which declined – 3.9%.  Short and intermediate term traders were the best performers of the group, while fixed income lagged as treasury yields spiked in the last two weeks of the quarter.  Overall, equity index exposure drove positive returns while energy and commodities detracted. The strategy has limited exposure to longer-term, trend following models but together with fixed income were the key detractors.

 

Fund Outlook

Our data gathering, analysis and discussions with underlying sub-advisers, leads us to believe that overall economic conditions are slowly improving in certain developed markets like the U.S.  This could result in decent and probably better than expected earnings results for Q1 2012, which of course are announced throughout the early-mid part of the coming quarter.  Risks are still prevalent and meaningful in regards to the European debt crisis, specifically Spain, and may continue to mute economic activity for this part of the world.  Finally, while evidence suggests that the major developing economies of China, India and Brazil are slowing, we believe that the risk of hard landings in these countries is small, especially in the coming quarter.

In addition, we believe correlation among equity prices will remain low enough in order to provide a reasonable security selection environment and that, while volatility will increase some from the very low level of Q1, it will remain within an acceptable range overall, thereby allowing for moderate levels of net exposure.

The opportunity set in fixed income, specifically the areas outside of high-grade U.S. Corporates and U.S. Governments, remains positive.  Balance sheets are in solid shape, cash flows are reasonable as economic activity has picked up, defaults should remain low for the foreseeable future, and spreads remain elevated, but are close to historical averages.  Therefore, from a risk-adjusted basis, this remains a relatively attractive area for us.

The resulting asset allocation changes to Alpha will mirror our above thoughts, however, the degree of changes we instituted for Q2 are minor.  We look to position the portfolio for a slight overweight to long/short equity and market neutral strategies, a solid overweight to relative value-long/short debt, underweight event driven and will maintain a neutral weighting to managed futures strategies.

As always, we value the confidence and trust you place in Hatteras Funds and the Hatteras Alternative Mutual Funds team in particular.  We take our job as fiduciaries seriously and strive to exceed client service expectations.  Please contact us with any comments, feedback and questions.

¹Performance data quoted represents past performance; past performance does not guarantee future results.  Net Fund Operating Expenses are contractually capped at 3.99% through April 30, 2013 and exclude dividends on short positions and interest on borrowing, as well as other extraordinary items disclosed in the prospectus.  Total Annual Fund Operating Expenses are 4.82%.  The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.  Current performance of the Funds may be lower or higher than the performance quoted.  To obtain performance information current to the most recent month-end, please call 866.388.6292.