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Emerging markets hedge funds navigate sovereign crisis

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Emerging markets hedge funds gained 4.7 per cent year-to-date through April, suggesting that many managers have navigated through much of the still-unfolding EU-centric sovereign debt crisis, according to Hedge Fund Research.

In addition to the significant weakness in the sovereign credit market, funds also encountered volatility in currency, commodity and underlying equity markets, with this volatility accelerating through 2Q10.

Risk-conscious investors repositioned capital in 1Q10, paring investments in emerging Asia while adding to exposure in Latin America and multi-emerging markets as total capital invested in emerging markets hedge funds increased to USD98bn.

Strong first quarter performance resulted in a USD5.3bn increase in emerging markets assets under management, which easily offset a small investor net capital outflow of USD560m; this marked the sixth quarter out of the last seven in which investors withdrew capital from emerging markets hedge funds. 

Some geographic rotation was evident in the most recent data, as redemptions from Asia (ex-Japan) and Russia/Eastern Europe-focused funds exceeded USD1bn combined, while investors added over USD500m to Latin America and funds investing in multiple emerging markets.

Hedge fund managers used a variety of tools to generate gains through the first four months of the year, including not only tactical exposure adjustment but effective use of protection from credit default swaps and various currency hedging techniques.

While sovereign weakness is presently concentrated in EU countries, many emerging markets managers began to deal with an escalation of emerging markets sovereign credit risk over six months ago (when risk was focused in the Middle East) by using CDS protection to insulate their portfolios from these losses and produce gains if the sovereign credit risks increased.

The HFRX Mena Index posted a gain of 7.9 per cent in 1Q10, including a record gain of 9.3 per cent in March, the highest monthly gain since index inception in 2005. Despite recent increases volatility in GCC sovereign credit, total Mena-focused capital has been steady and reflects a ten-fold increase since 2003.

Since the Rouble devaluation and Russian sovereign debt restructuring in 1998, funds investing in Russia have gained an annualised 23.5 per cent, the top performance region for the hedge fund industry. Despite annualised volatility exceeding 22 per cent, capital invested in Russia/Eastern Europe now represents over 35 per cent of all emerging markets hedge funds.

Investors allocated new capital to funds investing in Latin America while paring exposure to other regions, suggesting that investors expect Latin America to be insulated from the existing sovereign credit crisis. Over eight per cent of emerging markets funds are located in Latin America, fourth most geographically after US, UK and China.

Investors pared exposure to hedge funds investing in Emerging Asia, withdrawing over USD850m in 1Q10, despite these funds significantly outperforming Chinese equity markets for the period. The HFRX China Index declined by 0.75 per cent in 1Q10, a period in which Chinese equity markets fell by over five per cent.

“Throughout the ongoing EU-centric sovereign debt crisis, emerging markets hedge funds have continued to demonstrate strategic sophistication and performance resilience,” says Kenneth Heinz, president of Hedge Fund Research. “These qualities are likely to solidify and enhance the appeal of emerging markets hedge funds to global investors in the current environment.”

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