Tempted by the Latin allure

latin america

While Latin and South America have previously been regarded as a highly volatile market - in terms of equity, debt and political climate - it has proved a region of high returns from the hedge funds in its mature industry.

Guilherme Valle, hedge fund analyst at Connecticut fund of hedge fund (FoHF) firm ABS Investment Management, says Brazilian hedge funds can be divided in two groups.

The fundos multi mercado (multi-market funds), which mainly use fixed-income and equity instruments, and may be akin to global macro portfolios, are the first. Regulations dictate they must hold some local or offshore Brazilian government debt and have maximum equity exposure ceilings. The managers and markets benchmark these funds against the CDI interest rates, currently around 19.5%.

Then there are stock funds, which used to be known as FIA (Fundos de Investimentos em Acoes), invested mainly in stocks.

Ex-prop traders will generally open multi-market funds, Valle says. Those who were sell-side analysts usually opt for stock-heavy FIAs.

"The funds must have daily liquidity, and they deal daily but pay after a certain period, sometimes up to 60 days," Valle explains. He adds the daily liquidity funds offer can make investors sometimes unforgiving in withdrawals, "so a lot of the managers tend to run with a narrow band around the benchmark."

Valle says the daily liquidity makes assessing operational risk in a business critical: if the retail investors rush for the door of the onshore fund, will this affect the offshore performance or business as a whole?

"If managers have a lot of their money in the onshore fund and it's taken away suddenly, they may lose people on staff, for example," he adds.

PAN-REGIONAL FOCUS

While many funds in the region concentrate on their respective local equity markets, Valle adds, "some of the managers on the equity fund side are more active in other markets, usually Mexico. They may do something in Chile, but Argentina has been mainly a debt game."

Brazilian managers may trade Brazil's market, but Valle says this is "increasingly with their eye on the US Treasury market and S&P futures," a bifurcation of focus since the Asian crisis's contagion in 1997, which he dubs one of the main changes in hedge fund management in the region.

"They have to follow the Fed like someone trading Treasuries in the US; and on the stock side they have to know the companies and know what's going on globally."

SMALL BUT INSTITUTIONAL MARKET

Some investors less knowledgeable about the Latin and South American hedge fund market may assume that because its managers are not as well known as Europe and the US, for example, its investor base is also less educated about the benefits of hedge funds than their overseas colleagues. This is not the case."If you compare the Brazilian industry with the US or Europe, the Brazilian funds are much more institutionalised and most of them have come through distributors or big allocators. The industry is highly regulated by the local regulator, CVM, with the same regulation for mutual funds as for hedge funds," said George Wachsmann, partner at Brazil's Fiducia Asset Management, at Hedge Funds World's recent New York Global Opportunities 2005 conference.

Gary Kreps, CIO at America's Marathon Capital Management, notes spreads in Latin America have levelled out, making companies on single-to-low-teen P/Es "exceptionally attractive". He says Marathon may shortly be considering shorts in Brazil as well.

However, Krips cautioned investors to understand what they were getting into by investing in the region, and not expect a boom-of-no-give-backs.

"It is important to know the emerging markets well, and they have always not provided a smooth ride, so do not think the markets in Brazil of Argentina in five months will have doubled your money," he said.

"It is a long-term investment and be conscious of the risks you're taking. If there is a crisis in an emerging market, everyone will suffer no matter, where you are invested," he added.

Mauricio Levi, founder and CIO at Brazil's FAMA Investimentos, adds that from a macro-economic perspective, Brazil was passing through a period of income and credit growth, "which is still very low in emerging market and global terms, and a moment when investment in the equity market is still low.

"People are used to high interest rates and the risk, but now, or in the future as rates are lowered, they will have to look to hedge funds and other investments to continue to make their money grow," Valle says.

He adds that the region's markets are cheap on global terms and improving in terms of shareholder value.

"In Brazil, you have most of the liquidity in the market in the preferred shares instead of common stock - so they're non-voting stock. It was really bad in terms of corporate governance. But now there is a new wave of IPOs - GOL (a low fair airline) and ALL (railroads), for example - with IPOs embracing corporate governance, issuing common shares."

Ricardo de Campos, CIO at Hedging Griffo AM in Brazil, adds that, with the price of commodities high and rising, and the stock market standing at the beginning of a cycle of easing interest rates, now is a good time for foreign investors in Brazil.

Wachsmann says Brazil experienced a recovery after 2002's elections, and saw growth re-emerge in 2003-2004, giving way to a stock picker's market. Commodity firms and cyclicals have bucked the telecom-heavy local index's trend.

In Brazil, long/short funds account for more than $1bn of the $30bn in local hedge funds, also providing strategy choice for FoHF managers.

With a small proportion of the total assets of Brazilian pension funds invested in equities, and a small share market compared to Spain or Portugal - two other logical destinations for local investment funds - Levi says there exists a "huge potential for growth" in locally listed shares as money flows in.

Many local companies in Latin America also offer ADRs, notes Kreps; making Latin America, in his view, the most widely available region to foreign investors among emerging markets.

Levi says the best way to hedge in Brazil remains shorting the futures contract over the local stock, with 52 stocks offering daily settlement. "Equity loan in Brazil is a small affair and very expensive," he adds. "And while the futures index still has the premium of interest rates that are very high, when you sell the contracts, you end up earning about 85% of the interest rate, which is inside the futures contract."

De Campos says his hedge fund used the index future, while Wachsmann says that, in the past, he had also seen Latin American market managers use other markets' derivatives - such as those off indices of S&P and the G7 nations' - to hedge positions in local markets.

Kreps notes local exchange-traded funds were becoming increasingly liquid.

Levi notes that on a political front there had been concerns when a Leftist government took power in 2002, "but as the government has shown there is no alternative to sound economic policies, this fear has gone away.

"The country may go through another political crisis, but it will not have so great an impact as it had before. We have a stronger currency and our trade balance has gone up to around $160bn per annum."

Andres Azicri, managing partner at Argentina's Cima Investments, says managers in the region must still keep an eye on the region's political climate, but it is not the volatile region is once was.

However, he does note the region has watched with interest Argentina's sometimes aggressive approach to handling its debt.

"We think their response has started a new model of handling debt, of paying in good times and restructuring in a very aggressive way in bad times. Uruguay, for example, is looking very closely at this situation."

Cima's multi-asset class fund has made the most of regional opportunities, returning investors between 84% in 1999 and 11.1% in 2004.

Kreps adds: "I think emerging markets here for the next five to 10 years have moved beyond the situation where a crisis will be induced by a cyclical uptick in interest rates. They are now on their own path of growth and managing their own economies."

Kreps says Latin America's reliance on offshore indebtedness has been "decreasing remarkably over the last three to five years.

"On a relative value basis, looking at corporates and liabilities within sectors, companies in Brazil are, for the most part, attractive on a global basis as well."

He adds that supplying China and Asia with raw materials is a "core driver" of earnings growth in Latin America, diversifying away from the region's reliance on North America.

"We feel commodity prices will run further and feel growth is not centred on the US, so the US can slow to half the rate it was growing at and growth can still be at 3%, which will be a huge benefit to any country that has what China needs."

While a rise in US rates may drain liquidity in the short term, Levi says this could be positive if it drains capital that has entered South America seeking short-term returns.

"If we have a market correction, with interest rates going up and liquidity coming back to normal levels and you have the right stocks in your portfolio at that time, the portfolio could enjoy better years of growth."

Azicri feels emerging markets are "driven in large part by global liquidity."

De Campos is concerned that Brazil is eating into its reserves, at a rate of almost 15% in under a year. However, he thinks that this was not the kind of problem to break the deal with the IMF. Levi adds: "If the country needs the extra debt, I think the government will not offer resistance to sign the agreement with the IMF. The old Left that said we should tear up agreements with the IMF is not strong now and, if Brazil needs another debt, they will sign a new agreement."

De Campos notes currency exposure to Brazil's Real is "no longer an issue, since you have some of the highest interest rates in the world.

"Our companies have not really made any big investments in the past few years, so they are starting to take money from abroad and starting to make new issues in the US and Europe. This means the risks are on the positive side, and it's hard to see risks in money flowing out of the country," de Campos said.

Pablo Taussig, manager of the Patagonia Argentine Recovery Fund, adds investors might expect a return from Argentina of 10% to 20% for the coming two years, "as the domestic dynamic is completely independent of the euro rate and other emerging markets."

Investors wanting dollar exposure in their Latin American investments can use futures and non-directional forwards.

an innovative approach to debt: Bocones

Regional funds are nothing if not enterprising, as Buenos Aires firm Copernico Capital Partners shows. It recently found profitable plays in 'bocones', a lesser known debt instrument involved in Argentina's post-default restructuring

Not all of the country's non-corporate debt has been created equal, according to the company's managing partner, Ricardo Maxit. He explains that one set of quasi-sovereign issues - so-called bocones bonds - have proved particularly attractive, but have been harder to access by those playing the Latin American story remotely.

Bocones are Argentina's federal government consolidated debt issue that attends to the obligations it has to retirees and its own suppliers, and represent 2% of Argentina's total debt. Because they have been in retail creditors' hands, they have suffered more in price from Argentina's default than the global bonds authorities had issued. All investors in Argentina could buy the global bonds, but Maxit said Copernico's Latin American Strategic Fund bought bocones during 2004's second semester, and has profited since.

"When the exchange took place, prices of global debt and bocones converged," Maxit explains. When Copernico started accumulating bocones, they were trading at a discount of over 10 points compared to the globals, allowing an arbitrage play between global debt issued and bocones; now a pure convergence play as post-default Argentina becomes mainstream once more.

Mariano Caillet-Bois, also a managing partner at Copernico, said the bocones sat in both the Copernico Latin American Strategic Fund and the Copernico Argentina Fund, which closed to new investors in February.

The greater ability to buy bocones locally reflects Copernico Capital Partners' view, more generally, of the competitive advantage of being based in the markets in which the fund trades.

Copernico has not just gained insight into South American markets by its presence there, but also through an informal network of contacts throughout the region sharing investment ideas.

While this does not presently include other hedge funds, Maxit says this is more because of a dearth of locally based players than by design. Since respective launches, the Argentinean fund has returned investors 69.35%, while the pan-Latin American portfolio has returned 94.32%, according to figures from Copernico.

Latin America's potentially volatile stock markets have been one reason Copernico has worked with a generally lower net exposure more recently, and makes full use of protective instruments, such as credit default swaps for fixed income and index and stock shorting for shares, both locally through prime broker Bear Stearns and via ADRs listed in New York.

Copernico Capital Partners closed its Copernico Argentina Fund, started in February 2003, in March, at $61m. The fund began to make money after the recovery of Argentina's economy after its devaluation in January 2002. The fund has produced average annual returns of almost 33%, has an annualised volatility of 5.7% and a Sharpe ratio of 5.46. Its Latin American Strategic Fund, with $140m, remains open.

KEY POINTS

Brazil is the centre of South America's hedge fund industry, although funds are also making money in Argentina and Chile.

Managers note the political climate in the region has calmed notably since the heady days of Leftist rulers, and even more liberal governments are adhering with international development bodies.

Those conducting due diligence on Brazilian funds should note daily liquidity in domestic funds can cause problems for small operations if investors exit en masse.

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