South American hedge funds are catching the eye of European and North American fund managers, because, for the first time, the region is proving to be resilient in the face of global economic turbulence
The Latin American hedge fund industry has been developing rapidly since it first emerged in 1990. After Asia, South America now appears to be the promised land for investors seeking absolute and de-correlated returns. Hedge funds have been growing and multiplying in this region on the back of favourable economic conditions, where years of reforms and growth have begun to pay off.
Historically, the LatAm region has been associated with debt trading. Now, countries' balance sheets have become stronger, with balance of payment surpluses existing in many areas as governments begin to buy back their debt. Credit spreads remain near all-time lows and managers are beginning to focus their portfolios on the local currency debt and equity markets.
This year should turn out to be a good one for South American hedge fund markets. Although returns may not meet the record levels of recent years, for the first time, the region is proving to be resilient in the face of global economic turbulence. Local managers have been able to fully exploit opportunities presented by local markets, which are now able to attract and maintain a healthy level of liquidity.
More specifically, European and North American funds of funds are also beginning to set their sights on hedge fund managers from Rio to Buenos Aires. However, the concept of absolute return is no novelty in this market and certain hedge funds have already established honourable track records.
catalysts for growth
The region's hedge funds experienced a first wave of success in the late 1990s. They were championed by a number of wealthy local families, seeking to exploit regional markets' extreme volatility and keen to protect their gains in recurring market debacles. These pioneers mainly launched multi-strategy and global macro funds and did not necessarily limit investments to their home region. On occasion, they exploited opportunities in other emerging markets as well as the US, Europe and Japan.
The second catalyst to hedge fund growth in LatAm has been the combination of state defaults in Ecuador and Argentina in 2000, as well as the 2002 economic slump in Brazil and surrounding areas. Opportunities for distressed and event-driven strategies have multiplied in the region and global emerging market fund managers have started to reallocate assets away from the Far East into the LatAm markets.
Since 2004, new managers and strategies have developed in South America. In particular, long/short equity strategies have owed their success to the new-found buoyancy of regional equity markets, which have benefited from a strong liquidity expansion, numerous initial public offers (IPOs) and healthy consolidation trends in several sectors, such as telecommunications.
Another benefit for hedge funds in the emerging markets has been volatility, which has been a hedge fund manager's best ally in the region, because trading opportunities emerge directly from extreme swings as well as collapses.
South American managers are used to working in an environment where volatility averages 30% to 40%, which is twice the level of North American markets under quiet trading conditions. Certain hedge fund specialists have specifically built their reputations on the ability to generate very strong returns in periods of severe market downturn, with the scope for gains being more limited in times of market euphoria. Other managers, less at ease with the concept of short sales, prefer to wait for opportunities in distressed securities strategies. Such opportunities are never very far from arising in the region and offer sufficiently generous returns to offset less lucrative years.
In terms of running hedge funds, there are few essential differences between Latin American hedge fund managers and their counterparts in London or Hong Kong. Most have learned the trade on the proprietary desks of leading local or international banks. However, the LatAm arena houses some major personalities, such as Armínio Fraga (manager of Gávea Investimentos).
Fraga started fund managing with the renowned speculator George Soros before spending several years at the helm of Brazil's Central Bank. He sees the specific asset class being traded and the systemic volatility as the two distinctive elements in a Latin American hedge fund manager's day-to-day business. These factors have motivated him to always be prepared in the event of a drastic turn in market conditions.
In South America, Brazil represents one of the largest financial markets. This country alone makes up approximately 50% of the regional MSCI index. Brazil is unique among emerging markets in that it harbours a substantial demand on the part of domestic institutions, be it for foreign and local currency debt, on and offshore forex trading, equities, futures, interest rate derivatives or commodities.
According to hedge fund database Eurekahedge, Brazil harbours nearly 95% of total South American hedge fund assets. Hedge fund strategies are authorised in Brazil, by the country's Financial Market Authority, which sees these funds as a means to enhance the local market's flexibility and efficiency.
However, only certain alternative strategies have really evolved in Brazil, such as arbitrage and ethanol-backed securities. Meanwhile, the outlook for long/short equity strategies is rather limited owing to the high cost of securities borrowing. Nevertheless, this barrier also secures superior returns to those who know how to find securities lenders at the local level.
Furthermore, local Brazilian markets benefit from a unique opportunity, which has been recognised even by managers who are notoriously cautious about the country. Despite upcoming presidential elections and international uncertainty as to future world growth and liquidity, Brazil is not about to re-enact the meltdown of 2002.
For the first time, the country's fundamentals are sufficiently sound to enable the Central Bank to continue loosening its monetary policy, against the current global uptrend in interest rates. Nominal Brazilian interest rates have recently fallen under the 15% mark, compared to almost 20% a year ago. The market already expects this trend to continue, reflecting a marked slowdown in inflation, which has fallen below 4%.
This expected interest rate fall should continue attracting capital into Brazilian markets, offering liquidity, which will favour local hedge funds in coming months despite a rather pessimistic international outlook.
Overall, the scope for strong hedge fund returns in Latin America remains good, and the time for a market reversal is still far from ripe. The volatile trading conditions of LatAm will help the asset class in a more stable economic environment. However, in this promising context, one must be able to select those managers who will be able to fully profit from it, something not necessarily given to all investors.key points
Latin American hedge fund industry booming
European and North American managers looking to invest in region
Hedge fund industry benefited from volatile market conditions
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till