Morningstar Hedge Fund Report, July 2008

Hedge funds saw their worst monthly performance in the history of the Morningstar 1000 Hedge Fund Index. The index returned a negative 3.07% in July 2008, an eventful month for the markets.

In the first half of July, high oil prices and continued trouble in the U.S. banking sector caused equities to tumble and the U.S. dollar to slide, hitting a low point mid-month when the Federal Reserve expressed concerns about economic growth. The announcement of a U.S. government bailout plan for Freddie Mac and Fannie Mae, along with the Securities and Exchange Commission's short-sale restrictions on financial stocks allowed for a partial rebound in the second half of the month. "In July, the bet on long commodities and short financials didn't work as well for hedge funds,” said Daniel Farkas, hedge fund analyst for Morningstar.

Commodities showed their worst month in more than five years. The S&P GSCI Index, a commodities index heavily weighted in energy, fell more than 12% in July, as the price of crude oil plunged from its July 2 peak on weaker demand forecasts. European and Asian central banks attempted to combat inflation with interest rate hikes, causing a slide in those equities markets.

Consequently, the Morningstar Europe Equity, Morningstar Asia Equity, and Morningstar Emerging Markets Equity Hedge Fund Indexes saw much strife in July, though not as much as the Morningstar Global Equity Hedge Fund Index, which lost almost 8%. The Morningstar US Equity Hedge Fund Index also performed poorly, underperforming the S&P 500 Index by more than two percentage points.

"It's unusual for hedge funds to underperform equities in down markets, but hedge funds haven't been able to navigate the credit crunch that started last summer” added Farkas. The MSCI World Index outperformed the Morningstar 1000 Hedge Fund Index in four of the 24 down months since January 2003, the inception of the Morningstar 1000 Hedge Fund Index. Three of these four months occurred in the last year.

Because July also saw big losses in commodities, the Morningstar Global Trend Hedge Fund Index halted its upward trend. For the year, however, this index still outperformed every other Morningstar hedge fund category index by a wide margin. Year-to-date through June 2008, hedge funds in the Morningstar Global Trend category also experienced the highest inflows, at almost $10 billion. For the month of June, hedge funds overall saw more than $10 billion of inflows.

Multi-Strategy hedge funds had more than double the inflows of other categories, placing second only to Global Trend hedge funds. In a dynamic macro-economic environment, Multi-Strategy hedge funds can be more nimble than single-strategy hedge funds, quickly allocating assets to strategies with a brighter outlook, while pulling away from strategies with more dismal prospects. In July, however, most hedge fund strategies proved unprofitable, and the Morningstar Multistrategy Hedge Fund Index lost more than 3.67%.

Funds-of-Funds outperformed the Morningstar 1000 Hedge Fund Index in July, returning a negative 2.41%. Year-to-date, the Morningstar Hedge Funds of Funds Index has lost 2.52%.

Returns are based on hedge funds in the Morningstar hedge fund indexes that reported performance as of August 8, 2008.

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