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Magazine Issues » November 2011


ExplorerAs investors move further into emerging markets, where does this leave hedge funds? Nick Fitzpatrick says that following the summer equity sell-off the industry is at an important juncture for proving itself mature enough to become a portfolio staple.

If emerging market investment is to become the “new normal” for many European investors, there are advocates who say hedge fund strategies in this sector – there are about 1,000 of them according to Hedge Fund Research (HFR) – should be more widely considered.

The asset flows out of emerging markets in August and September during the equity rout could give these funds, whose major strength should be downside protection when markets become more volatile, an interesting opportunity to prove their value.

Volatility is one significant put-off for would-be emerging market investors, and though this has been a concern across all equity classes in recent months, it has been the case for emerging markets for much longer.

The effect of “hot money” chasing opportunities in these markets is very likely to be compounded by the smaller capital size of the stocks available in what is already a smaller stock universe compared with developed markets, where hot money can be more easily absorbed.

“There are times when there is a rush of money into emerging markets and then a rush out of them again,” says Nigel Gliksten, head of client service at Toscafund, an asset manager based in London and Dubai. “[Emerging markets] is clearly a volatile asset class. Sometimes it’s good to protect and survive and the hedge fund structure helps with that.”

Money has certainly been flowing away from emerging markets lately, and during this time the Tosca Emerging Markets Fund, a global emerging markets long-short fund that takes long positions in stocks it expects to outperform and shorts those it does not, has had a short bias, refelcting concerns over fundamental valuations and various top-down considerations.

A slight glimpse of how hedge funds have performed in emerging markets lately is available from Eurekahedge. Tentatively, it could be seen as promising. The year-to-date return for Eurekahedge’s Latin American Hedge Fund Index at the end of September was 0.17% compared with the MSCI All Country Latin American Index, which was down 27.96%. Onshore Latin American hedge funds contributed significantly to this return on the back of high interest rate deposits of the Brazilian real.

Advocates of greater emerging market hedge fund investment for mainstream investors include Cambridge Associates, which earlier this year called on institutional and private investors who believe emerging markets offer the strongest long-term growth opportunities to consider treating their emerging market exposure in the same way as they would their exposure to developed markets, with a mix of assets and strategies, including private equity and hedge funds.

Eric Winig, a managing director at the US consultancy, said at the time that most emerging market allocations by US and European investors consisted largely of long-only strategies and were overly concentrated in certain regions and countries, with exposure pretty limited to multinationals such as Gazprom and Samsung.

“In other words, most investors are essentially invested in giant companies largely based in the Brics [Brazil, Russia, India and China]. These investors may be missing opportunities with smaller companies that are more directly exposed to emerging market economies.”

Cambridge aimed the recommendation at investors who are looking at an emerging market exposure of beyond 5% of their total portfolio. Winig said they should look to hedge funds to generate equity-like returns and lower volatility over the long term, and do more to exploit inherent inefficiencies in the emerging market universe.

One sign of an inefficient market is illiquidity, which for hedge fund clients is likely to be as significant a consideration as volatility, in some way perhaps more so. This is particularly the case for the hedge fund of fund (HFoF) industry, which was caught in a liquidity trap after the collapse of Lehman Brothers in 2008, when client redemptions outpaced the ability of underlying hedge funds to unwind from less liquid investments.

Gottex Fund Management is a London-based alternative fund manager with around $8.9 billion (€6.5 billion) under management, including in an FoHF business.

Chris Hawkins, portfolio manager, says the firm has less of its global portfolios invested in emerging markets now than in 2007. “The reason is not that opportunities are fewer, but because liquidity is lower and the opportunities do not currently compensate for the risk posed by reduced liquidity. Emerging markets were in vogue in 2007 and since then liquidity has dried up substantially and not recovered, meaning alpha is less available.”

Challenges ahead
Hawkins’s colleague, Ted Wong, portfolio manager of the Asian-focused Gottex Tiger fund, adds: “[Liquidity] is extremely important because a lot of emerging market investing tends to be mid-cap. The issue is that companies are smaller.”

This may be a challenge but at least this plays to Cambridge Associate’s point that hedge funds could help investors diversify away from the long-only tendency to concentrate in the largest companies of the largest developing markets.

Whatever the challenges of emerging market hedge fund investing, perhaps people are ready for them, because there is a small sign that investors are starting to do what Cambridge Associates would have them do and invest more in emerging market hedge fund strategies.

Prior to the summer outflows, emerging market-focused hedge funds had seen inflows of $300 million in the second quarter of the year, according to HFR. It was the fourth consecutive quarter that these funds saw positive inflows.

They also saw a broader increase in assets under management through their performance. Performance-based returns totalled $1.1 billion in the second quarter and total assets invested in emerging market hedge funds stood at $123 billion, a new record.

Macro hedge funds posted a performance gain of around 9% in the second quarter, which compared to a 1.67% loss for global macro hedge funds. Wong, at Gottex, says macro strategies will have more impact over the next couple of years.

“In the past twelve months we significantly increased exposure to macro managers from 5% to over 25%, and we have included emerging market macro managers to our Asia portfolio.”

This decision appears to have helped Gottex’s Asia portfolio cope well with the summer turbulence.

“The Asia portfolio was up in August and September. Macro managers had protected the downside of the portfolio,” said Wong.

If there is a consensus on what investors want from emerging market hedge funds, it is tactical exposure to macroeconomic trends, as well as growth. They also want hedged, uncorrelated exposure to developed market equities. While results at the end of the second quarter look promising, the third quarter’s results will be more telling about how successful these funds are, whether they managed to offer downside protection as well as they did in the first few months of the year.

Unfortunately for managers, there is a bad omen. The Emerging Market strategies followed by Edhec-Risk Institute show a 6.71% loss in September, by far the highest loss out of 13 strategies. However, this does not differentiate between different emerging market strategies, and the annual average return for the grouping since January 2001 is significantly the highest, at 10.5%.

It also has to be noted that the S&P 500 was down further than emerging market hedge funds in September, posting a 7.03% loss.

All in all, the emerging market hedge fund world is showing some signs that it is becoming what Cambridge Associates envisages: a normal part of emerging market portfolios. Emerging market opportunities for alternative and traditional investors are more appealing than anywhere else, but the process of capturing them often involves more expense and risk. Investors should consider that this is even more the case with hedge funds.

©2011 funds europe