Alternative Investment Management Association
Enio Shinohara and Peter Douglas, CAIA respectively
Claritas Investments and GFIA Pte Ltd, respectively
Latin America accounts for 6 percent of the world’s GDP and 9 percent of the world’s population1. Its capital markets are bigger than those numbers would suggest.
Similarly, it is not an exaggeration to say that Latin America is still an under-represented region in the global hedge fund industry. With an estimated US$ 34 billion of assets2 144 hedge fund managers (Figure 1), it represents less than 2 percent of the total universe.
The majority of Latin hedge funds are focused on Brazilian markets and Brazil is where most of the assets and managers are. Hence the main focus of this article is the development of the Brazilian hedge fund industry.
Figure 1: Assets under management and number of managers
Sources: Claritas (proprietary database), ANBID, Eurekahedge
Number of managers does not include emerging markest hedge funds with an exclusive mandate of Asia and/or Easter Europe. We adjusted the figures for double-counting in the case of managers which run more than one fund.
At a glance, the first thing to notice in Figure 1 is the predominance of the Brazilian hedge funds, both onshore and offshore, totalling US$ 31.6 billion of assets. Funds that have an explicit Pan-Latin America mandate, typically with a heavy weight in Brazil; these funds have in aggregate around US$ 2.9 billion of assets. Finally, funds that cover the entire emerging markets universe, where Latin America corresponds to an average exposure of 20-40 percent of the invested capital - that group have an estimated US$ 50.9 billion of assets.
We estimate that more than two-thirds of the recent growth came from asset appreciation (for the specific case of Brazilian onshore hedge funds, assets also grew due to the currency appreciation, since these funds are denominated in Brazilian Reals) and the balance came from net inflows, including the newly established managers.
Latin capital markets offer good liquidity, depth and volatility. Notably, the most liquid markets are fixed income (cash, bonds and derivatives) with relatively long yield curves with a variety of derivatives. Currencies are still not fully convertible but there is good liquidity in spot/derivatives markets.
Latin equities are liquid, especially companies that have listed ADRs in the US. In terms of locally traded stocks, the Brazilian stock exchange is by far the most liquid in the region, averaging US$ 2.4 billion of daily turnover. The wave of IPOs in Brazil in the last few years has been very helpful in improving market liquidity - 56 companies pursued IPOs in the Brazilian exchange in 2007, alone.
One question often raised by investors, is the availability of instruments to hedge equity risk. Stock borrowing in Latin America is certainly not as easy as in the US, but there is a reasonable array of instruments to short. According to the estimates of Claritas equity team the short interest of both shares traded in Brazil and Brazilian ADRs averages US$ 18 billion from more than 100 companies. In addition, to single stocks shorts, in the Brazilian stock exchange and in the derivatives exchange, hedge funds can use index futures/options, ETFs and stock options, which trade over US$ 3billion/day (notional value).
The inception of the hedge fund industry in Latin America was a by-product of the economic stabilisation plans that contained hyperinflation in Latin America, from the 1990s. The first local Latin hedge funds appeared in Brazil in the mid-1990s.
We can identify four major milestones for the hedge fund industry:
1. The end of hyperinflation in the early 1990s and growth of influential local investment houses, notably well developed investment banks with big risk appetite. At that time, there were not many independent hedge funds as we know today but the proprietary trading desks operated as true hedge funds.
2. Following the Asian and Russian crises (1997/98), consolidation of the hedge fund and mutual fund industry and strengthening of the leading banking system.
3. The retrenchment of foreign investment banks’ operations in the Brazilian pre-election (2002) which triggered a new harvest of managers.
4. The emerging markets bull cycle (2003-2007) which prompted higher growth in terms of new hedge funds and capital raised.
Most hedge fund strategies are represented in the region.
Out of the universe of 144 hedge fund managers, we estimate that almost half of them are macro funds. These and the stated multi-strategy managers are hedge funds that mirror the shape and dynamics of an investment bank proprietary trading operation – some of them are, as or more, aggressive than prop traders although this is the exception and not the rule.
Figure 2: Strategy breakdown (% assets)
The so called multi-strategy does not resemble US multi-strat funds. We see them as another form of macro funds, the difference often being more in the internal organisational structure of the firm, rather than the fund’s investment objectives.
The performance of that strategy over the last few years has arguably declined and this has been driven by the remarkable improvement of the macro environment across the region. As a result of that, macro inefficiencies are now scarcer.
Given this scarcity of opportunities in the macro trading space, we do believe that macro managers will be forced to reshuffle their business models and “reinvent” themselves. One of the viable and often used solutions has been the increased exposure to equity markets.
Long-short equities managers form a heterogeneous group, ranging from the more directional managers, with fairly concentrated portfolios and sometimes very active trading, to the more “neutral” managers, who emphasise pairs trading with low net exposure.
This is the fastest-growing strategy in the region, now representing more than one-third of the number of managers and a little less than one-fourth of the assets.
The split between directional equity managers and more “market-neutral” managers was relatively balanced until a year ago but now there is a clear predominance of less directional managers.
As a result of the rampant liquidity in Latin equity markets, long-short equity funds have been multiplying. Today, more than one-third of the hedge fund managers run long-short equity portfolios. A couple of years ago, that figure was less than 10 percent.
Fixed income managers tend to focus on the more liquid fixed income markets, notably engaging in yield curve trading, interest rate and credit trading.
More recently, we have seen interesting developments in fixed income. At the same time as the stock of US$ denominated sovereign debt is falling, a tremendous increase of local currency denominated debt is taking place. We are also seeing the emergence of other fixed income instruments (e.g., asset backed securities).
As in other emerging markets, some managers are increasingly focusing on less liquid assets or “special situations” (including private-equity–like situations).
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In terms of regulation, onshore and offshore funds belong to very distinct universes. Brazilian onshore hedge funds are backed by an advanced regulatory framework.
The Brazilian Securities Commission (CVM) supervises the whole industry including investment management companies that are based in Brazil. The regulation of the managing companies and the individuals is quite strict.
ANBID (National Association of Investment Banks) represents most of the asset management companies in Brazil, including the bigger hedge fund groups and also acts as a self-regulatory entity.
Opportunities, risks and future developments
We see the combination of a supply of good investment professionals and inherently inefficient capital markets in Latin America as an interesting opportunity for allocators in hedged products.
So far, the demand for Latin American hedge funds has been predominantly local, which can be seen by the large number of onshore hedge funds in Brazil. Demand from international investors today is much bigger than five years ago but interest has not translated into massive inflows.
For allocators in general, the region offers an interesting opportunity of investing in highly skilled but relatively unknown managers. However, finding a mix of strategies sufficient to diversify a portfolio, finding enough asymmetric volatility and finding appropriate hedges to use within a portfolio of Latin funds, remains a challenge for even the most experienced Latin allocators.
On the supply side, we believe that the pipeline of new managers will continue to be mostly filled by local talent. High entry barriers exist for managers that do not have local knowledge/presence.
The successful non-Latin managers are the ones who have been trading in the region for a long time. Language is not a critical barrier but knowledge of local markets is.
Generally speaking, one of the key challenges going forward for hedge fund managers is how to handle the asset growth without diluting performance.
As mentioned before, there are fewer opportunities in the macro space, so we might see a further degree of specialisation in certain niches. Not having equity expertise is no longer an option for macro managers. For long-short equity managers, one of their crucial challenges is to prove that they are able to extract alpha from their shorts and to hedge their longs efficiently.
Finally, we also think that hedge fund managers will have to adapt themselves to a more globalised market environment. Recent developments serve as strong evidence that the “decoupling” argument does not apply for Latin America. That will ultimately require, from managers, a better comprehension of what is going on in other markets.
1 Source: World Bank
2 Claritas estimate, on the basis of data collected from Eurekahedge, ANBID and Claritas proprietary database.