Funds investing in Latin America - mostly based in Brazil - enjoyed outstanding results between 2002 and 2004.
Although the environment seems more difficult in 2005, the fundamentals appear sound and longer-term prospects are excellent.
The primary reasons for this success are macro-economic. The politico-economic background has stabilised since the Argentine crisis of 2001. Despite the recent problems encountered by the governing Workers Party in Brazil and the significantly weakened position of president Lula, the hyperinflation of the 1990s seems to be gone for good.
The Brazilian banking sector in particular has been bolstered and consolidated, permitting a reduction in leverage and therefore in systemic risk to the financial system. A further contribution toward stability stems from the trend toward lower interest rates.
An additional positive factor is the quality of the Latin American, and especially Brazilian, financial markets. Latin America's capital markets offer good liquidity as well as a level of volatility that is advantageous to hedge funds, and the same applies to the spot and forward forex markets. Large cap stocks are very liquid, especially those Brazilian shares traded on US markets as ADRs.
As for derivatives markets, certain contracts such as local interest rates traded on the Brazilian Mercantile & Futures Exchange in São Paulo are among the most liquid instruments in the world. On a global scale, volatility is high, allowing fund managers to achieve extremely good performance with low levels of leverage.
A particularly interesting development is the explosion in the number of local hedge fund managers. Following the retrenchment of a number of large international banks in 2002 as a result of the Argentine crisis, many of the banks' proprietary traders used their skills and experience to establish their own private asset management firms, leading to the creation of many independent hedge funds. Today there are some 220 Latin American hedge funds managing around USD 20bn. This may represent just 2 per cent of the global hedge fund industry but their appearance is significant.
Another improvement is in the diversity of strategies offered. A majority of funds use a multi-strategy approach suitable for the changeable and volatile Latin American markets. In order to take maximum advantage of the ever-changing opportunities in these markets, managers adopt flexible mandates that allow them to use whatever strategy is most appropriate at any particular time.
There are also fixed income arbitrage managers who mostly trade sovereign debt and a significant number of managers offering distressed debt strategies, an approach that has benefited from events in Latin America such as the economic and political crises in Argentina and Ecuador and the devaluations in Venezuela and Brazil.
Finally, there are two types of managers using equity strategies, directional or market neutral, although neutrality is a relative concept in such inefficient markets. Finally, since 2004 we have seen the establishment of the first funds of funds specialising in the Latin American region.
A further positive aspect is regulation. The offshore funds managed by Latin American firms tend to have the same characteristics as their European or North American counterparts. They are generally structured as mutual funds or investment companies set up under the jurisdiction of the Cayman Islands, Bermuda or the BVI. Perhaps more surprising, onshore regulation is particularly well developed, especially in Brazil.
The vast majority of onshore Brazilian funds offer daily liquidity, and payments for redemptions are made within one to four working days. The Brazilian Securities Commission supervises mutual funds and hedge funds, and monitor leverage levels and portfolios on a daily basis.
For investors, the combination of highly skilled finance industry professionals and the inefficiencies that characterise the Latin American markets represent a promising source of investment opportunities. Relatively little known managers, combined with capacity that remains largely unexploited and strong medium- and long-term growth potential, make the region particularly attractive for hedge fund investment.
This is the theme of the Latam Hedge Funds 2005 conference, which will be staged at Geneva's Mandarin Oriental du Rhône hotel on October 25 by hedge funds specialist Jetfin and financial conference organisers Academy & Finance . The event will provide a platform for fund managers who specialise in the region to answer investors' questions and help them to understand the stakes involved in investment in this part of the world.
Hedgeweek's Special Report on Latin American Hedge Funds will appear in early October.
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