Emerging managers spread their wings
A new focus on Latin American alternative assets among foreign investors starved of substantial returns at home is coinciding with the emergence of a new breed of managers in the region whose skills have been honed amid the political, economic and financial turbulence that have repeatedly afflicted Latin countries and occasionally the entire region.
A more benign economic environment, including lower inflation and interest rates, along with the increasing availability of sophisticated financial instruments, is prompting managers to branch out from the multi-strategy and global macro approaches that still account for the majority of hedge funds, at least those that targeting a domestic clientele.
The new focus on the region by investors represents full circle in a cycle that began in the early 1990s, when emerging markets were strongly in fashion, only for portfolio investment to progressively flee the region in response to a series of setbacks that included economic and/or financial crises in Mexico, Russia, South-East Asia, Argentina and Brazil.
Says Florian Bartunek, a founding partner of Constellation Asset Management in São Paulo: 'We have never seen such big demand for Latin American managers from outside. Global liquidity is very large, and there's a huge search for yield, so people are looking at emerging markets.'
Constellation manages USD105m in assets in long/short equity funds that invest in the whole of Latin America, but with a strong Brazil bias - around 70 per cent of the portfolio consists of Brazil related trades. Most of the money - USD82m - is in a Cayman-based offshore fund, although the firm also runs a long-only domestic fund that is now closed.
Says Bartunek: 'When the fund started, it was mostly Latin American investors, but now the new money is mostly from US and European institutional investors who are seeing that Brazil has large managers with a long track record' - and who are impressed by an annualised return of around 19 per cent, seven per cent volatility, and no down year since 1999.
He says the approach of North American and European investors to emerging markets has evolved in distinct stages. 'When people invested in emerging markets 20 years ago, their first thought was to hire a big US or European name to manage your money, like Capital, Scudder or Mercury.
'Later, instead of outsourcing the management of emerging markets money to the likes of Merrill Lynch, people turned to emerging markets hedge funds, based in New York or London. In the third wave, they are asking why they should pay someone in New York who is trying to invest across all emerging markets to manage assets in Brazil, Malaysia or Turkey, when they can invest in a local manager, who is much more aware of what is going on locally.'
He is echoed by Antonio Machado, a partner with Paraty Investimentos, who says:
'The trend over the years is toward greater interest in local managers. In 1992-95 there was a lot of interest in local managers. Then came the Mexican crisis, and interest continued but was slow, but after the Asian and Russian crises demand switched to global players, and Latin American funds had global outflows between 1998 and 2002. From 2002-04 there was renewed interest, but much less than in the years before 1995, and now we are entering a period in which flows from global to local players will increase.'
This process started with Asia, Bartunek argues, because a couple of years ago growth rates there were much higher than in Latin America. 'But now people are looking at Latin American managers for two reasons,' he says. 'First, they may generate alpha for offshore investors. Most of fund of funds' emerging markets exposure is in Asia, so investing in Latin America probably differentiates you from your peers.
'At the same time, there is a thriving new hedge fund industry. Foreign investors that come to Brazil are positively surprised by both the quality of the people, and the liquidity and depth of the local financial markets. We're in the sweet spot, in the sense that you have global demand for emerging markets, demand for Latin America to diversify that emerging markets exposure, and a flourishing local industry. In addition, people are positively impressed by the level and sophistication of the hedge fund regulation in Brazil.'
Brazil is the cornerstone of the Latin American hedge fund market, accounting for the lion's share of a regional industry estimated at more than 220 dedicated funds and assets in excess of USD25bn. According to Enio Shinohara, a well-known analyst of the industry and now an emerging markets fund of funds manager at Claritas Investments, one factor is that unlike in Argentina, Chile and Mexico, Brazil has long had a strong domestic investment banking industry.
Shinohara and other market observers say many of today's hedge fund managers in Brazil are the product of a shake-out in the investment banking industry around 2002-03.
He says: 'The presence of these good proprietary traders at local banks explains why there's so much talent in the hedge fund industry in Brazil compared with other Latin countries.' Elsewhere, he says, the talent has migrated to the United States: 'It's hard to find good Argentine and Mexican traders in their own countries, but you find lots of them in US investment banks or in emerging market dedicated hedge funds in New York.'
The fact that a minority of managers have a long track record may be an issue for foreign investors. Says Bartunek: 'I would feel more comfortable giving money to someone who has been managing money for 20 or 30 years, but unfortunately you do not have many in Brazil. On the other hand, it's said you can count managers' professional experience in 'dog years', because it's been so volatile in the past. If someone survives for 10 or 15 years, it's like an entire career somewhere else.'
The development of hedge funds has also benefited from the problems of long-only equity funds in a market that has a tradition of turbulence and where in recent year's equities have struggled to match the extremely high real returns offered by fixed income investments.
Although interest rates have come down slightly, government bonds currently earn 19.5 per cent per annum, a high hurdle for a long-only manager when the risk of equities is much greater. 'Brazilian investors are accustomed to fixed-income rates among the highest in the world,' says Dara Chapman, head of sales and investor relations at Polo Capital Management. Says Palazon: 'The hedge fund industry is growing a lot in Latin America, because the traditional mutual fund business does not work well. When you have a crisis, all assets fall in value, and you lose most of your money, whether you are investing in bonds or equities - whatever you hold is correlated in the same direction. That's why flexible types of investment are more appropriate for emerging markets.'
Both long-only and long/short equity investments are likely to gain in attractiveness as interest rates come down, but in the meantime Brazilian banks have capitalised on the situation by offering funds of hedge funds to a retail investor base with investment minimums of as little as USD2,500.
The history of volatility that makes long-only investment less attractive also explains the preponderance, at least until now, of an overt multi-strategy style, or at least a flexible approach to investments. Says Carlos Palazon, chief investment officer at Cima Investments in Buenos Aires: 'We invest mostly but not exclusively in emerging markets, which allows us a lot of flexibility regarding the type of investments we do.
'We don't want to be invested if we don't see any opportunities, and we don't want to miss opportunities because our prospectus restricts us from this kind of investment. In the past many funds disappeared because they had no good ideas to invest in. We discovered the need for a very broad and flexible investment policy.' According to research by Eurekahedge, more than 70 per cent of Latin American onshore hedge funds as measured by assets are multistrategy funds, with long/short equity accounting for 12 per cent, macro six per cent and distressed strategies four per cent. Among offshore funds, however, distressed debt is the most popular strategy with 46 per cent of assets, followed by long/short equity with 20 per cent and fixed-income strategies with 15 per cent; multi-strategy funds make up just eight per cent.
Says hinohara: 'The fact that domestic funds are mostly multi-strategy and macro is a consequence of the shape of the capital markets, the availability of debt, fixed income, and currencies. However, the equity markets have evolved strongly in the past two or three years - volume has increased exponentially, and the number of traded equities also has increased.
'That's why long/short equity has become significant over the past 18 months to two years. Secondly, distressed is a very good strategy because of all the defaults and restructuring in Latin America over the past five years,especially in Argentina.'
Says Chapman: 'Multi-strategy is a significant part of the market here, because you're able tovhit all the angles. However, I'm not sure how well the offshore market would perceive that kind of approach, because it's difficult to decide where the alpha of the manager is. That kind of strategy works better with onshore managers, who have different due diligence processes.' Most managers agree that the flow of international assets into Latin American funds will lure more managers into the market, but they are not convinced that all, or even many,will be successful. Says Bartunek: 'People who do not have the expertise open long/short funds simply to get a chunk of this new money. At the end of the day, you will have four or five large equity long/short funds that are successful, and a lot of the new ones will die.'
Copernico's Maxit agrees the industry will keep on growing, albeit at a slower pace. He says: 'The barriers to entry are not very high. Anyone can open a hedge fund and start a business. The economics are very attractive, so a lot of people will try to come into the industry. The cost structure here is low, there's a very entrepreneur-friendly environment, and there's a large number of traders, so you have the skill set. But opening up a fund is the easy part - the hard bit is to deliver returns consistently.The barriers to success are much higher. You see a lot of funds open and assets are growing,but assets can also leave very quickly.' Maxit notes that many onshore funds that have offshore mirrors don't do much - or any - marketing at present. He says: 'For most groups the focus is on Brazil because it's their backyard, and they find it easier to raise money here. It's a very long process to raise money from non-Brazilian investors. Everything here has a more short-term focus, so groups tend to put more of their energy into the onshore market.'
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