Global Market Review
The global equity markets performed well in the fourth quarter as represented by the MSCI World Index return of 4.53% (in local currency). This compares favorably versus domestic equity returns, with the S&P 500 Index up 2.08% for the quarter. The global equity outperformance also holds for the year with the MSCI World Index up 16.34% (in local currency) compared to the S&P 500's 4.91% return for 2005. For the global convertible market, both fourth quarter and full year returns were modest as the Merrill Lynch Global 300 Convertible Index returned 1.39% and 0.18% respectively.
Positive equity returns were broad based, with all but four of the 23 countries represented in the MSCI World Index posting positive returns for the quarter. Japan showed the strongest absolute performance, followed by the Netherlands and Switzerland. The countries in negative territory for the quarter were Hong Kong, New Zealand, Norway, and Spain. For the calendar year, all of the developed market countries posted positive returns. Japan's impressive 44% return (in local currency) for the year led the way as the markets seemed to recognize some of the pro-growth reforms the country has undertaken that may result in improving economic fundamentals.
Although Japanese convertible securities performed particularly well for both the fourth quarter and full year, the primary reason behind the low 2005 returns in the global convertible market was the selling pressure from convertible arbitrage hedge funds. Convertible arbitrage is a popular hedge fund strategy that has a history of delivering consistent returns with low risk. In the recent market environment (marked by low interest rates and low volatility), the returns that convertible arbitrage hedge funds have produced have disappointed investors. This disappointment has led to redemptions, which in turn has led to the hedge fund community selling into the convertible market. Since hedge funds operate in the global markets, the selling pressure was seen in the convertible market globally. This selling pressure has depressed prices in the convertible bond market, and created some of the best valuations we have seen since 1987. While the chart on the following page illustrates all U.S. convertible issues, it represents the opportunity that exists within the global convertible market. Historically, we have seen the convertible market trade between a 1.5% discount to a 2.5% premium to our fair value estimate. As you can see, valuations have declined within the convertible market recently.
As of year end, according to our valuation tools, the U.S. convertible market is 2.75% undervalued. This selling pressure and decline in valuations has limited the returns in the convertible market this year. A similar phenomenon happened in 1994, as the Federal Reserve was aggressively raising rates, convertible valuations declined. The valuation collapse that occurred in 1994 was relatively short lived and convertibles returned to more normal valuations.
While there is still some hedge fund selling in the convertible market, it is not as intense as it was towards the beginning of the year. We have seen valuations improve somewhat over the past several months, however, valuations still remain attractive.
Current Portfolio Positioning/Outlook
The global opportunity is still very strong; however, in some of the developed countries the markets are ahead of the economic fundamentals. While Europe and Japan's equity markets performed very well despite their economies being significantly weaker than the U.S. economy, the markets generally predict economic strength. The seeds have been laid for improving economies in Japan and Europe, with leading indicators improving greatly in both areas and additional support from low inflation and interest rates. Voters in Germany, France and Japan have called for a change, and one should expect some strong encouragement by consumers for further growth and opportunity. It makes sense to have investments in these markets as a wave of change occurs and they join in on the global expansion.
We continue to find attractive opportunities within the global convertible market as valuations remain attractive. Throughout 2005, we have increased our allocation to convertible securities, taking advantage of their excellent risk/reward profiles given the relatively low valuations. Looking ahead, we will continue to position the portfolio to take advantage the valuation opportunity within the convertible bond universe.
Most of the portfolio's currency exposure was hedged over the course of last year. While this hedging activity added to returns as the U.S. dollar performed well for the year, we are not expecting to create significant currency returns over a full market cycle. We expect to generate returns through good bottom-up security selection as well as top-down portfolio positioning. Our currency policy is expected to remain consistent going forward—we anticipate continuing to hedge foreign currency risk. Over a full market cycle, this hedging policy will allow the portfolio to benefit from our selection and portfolio positioning, and lessen the impact of the foreign currency markets.
Overall, we continue to be optimistic regarding the global market, and we will focus our attention on those areas of the world that are embracing pro-growth, free market principles.