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Key Trends in Latin American Hedge Funds1
Eurekahedge

September 2005

Latin American Hedge Fund Market Overview

The size of the Latin American hedge fund market (including both onshore and offshore funds) is around US$24 billion, representing approximately 2% of the global hedge fund industry. There are close to 200 hedge funds with a Latin American mandate, which saw an annualised growth rate of assets close to 60% since 1991.

Fig 1: LATAM Hedge Funds Cumulative Assets

Source: Eurekahedge

For the purposes of the report we have divided the Latin American region into "offshore" and "onshore" funds. Of the total size of the Latin American hedge fund industry, offshore funds account for around 70% of the total assets largely because offshore funds are usually denominated in US dollars and face lesser regulations which attract global investors, whereas onshore funds are mostly funds denominated in local currencies, exposing the investors to local interest rates and currency risks. The assets of onshore funds have been growing at a phenomenal rate of around 120% per annum since 2000 as opposed to offshore funds which grew at 26% per annum over the same period.

General Performance Overview

Since 2000, onshore Latin American hedge funds produced a mean return of around 26% per annum while offshore funds returned 17% per annum. This perhaps explains the reason for the explosive growth in onshore funds. The other reason could possibly be the improving macro economic indicators for the Latin American economies, particularly Brazil, which is home to 95% of all Latin American onshore funds. Brazil has been seeing an influx of new managers during the last five years mainly due to closures of investment banks in Brazil, which forced money managers to set up their own shops. The increase of Brazilian onshore assets into alternatives has motivated managers to leave established houses. Success stories like Gavea and JGP have also been an inducement.

Fig 2: Performance Overview

Source: Eurekahedge

Latin America Regional Economic Overview

Performance of the Latin American equity markets from beginning of the year to July 05 has been mediocre, registering a modest (as compared to previous years) return of 15.84%. March and April came under some selling pressure mainly on concerns over the economic growth of the US economy. The US yield curve is flatter than a year ago, indicating a possible slowdown in the US economy which might induce bearish trends in the global markets.

Latin American commodities returned with a vengeance this year after being range-bound for almost a year, due largely to the strong demand from China and India. Latin America's bilateral trade with India reached US$14 billion in 2004, up from US$1.8 billion in 2001.

The political environment in Latin America is also heating up as Brazil prepares for election in 2006. This would possibly mean increased spending by the government in 2005. However the fiscal balances should be in check, helped by strong tax receipts and export earnings.

Overall the Latin American economies remain strong with sound fiscal management and balance of payments as compared to the '90s.

A Closer Look at Onshore Funds

Onshore funds account for around 30% of the Latin American hedge fund assets, out of which more than 70% follow the multi-strategy investment style. This is possibly due to the dynamic macro economic environment of the Latin American markets wherein a multi-strategy style provides the managers with greater flexibility in making investment decisions.


Fig 3: Breakdown of Onshore Funds by AUM

Source: Eurekahedge

In terms of number, multi-strategy funds also make up around 70% of the total onshore funds, confirming the popularity of this style.

Fig 4: Breakdown of Onshore Funds by Strategy

Source: Eurekahedge

All strategies within the family of onshore funds have been generating double-digit annualised returns since 2000.

Fig 5: Performance of Latin American Onshore Funds
Strategy
Annualised Returns (%)2
YTD (%)3
2004 Returns (%)
2003 Returns (%)
CTA/Managed Futures
21.06
-7.41
23.74
19.91
Event Driven
42.03
15.93
39.54
36.13
Fixed Income
25.86
10.32
15.60
39.25
Long/Short
19.58
6.92
35.27
55.83
Macro
16.50
4.15
6.63
9.80
Multi Strategy
24.24
9.15
19.65
36.39
Relative Value
44.91
-6.62
48.56
54.11
All Strategies
23.92
7.57
22.22
37.01
Source: Eurekahedge

Assets flow wise; it was the macro, multi-strategy, CTA and long/short equities funds that saw most of the capital inflows during the last five years. The chart below shows the phenomenal growth rate in their assets since 2000, which ranged from 70% to 140% per annum. The reason for this has to do with the good showing of the Brazilian economy which grew by around 5.3% in 2004 on a year-on-year basis and benefited most from the high commodity prices. Employment rate are rising and consumer demand is improving, thanks to the expansion of micro credits.

Fig 6: Latin American Onshore Asset Growth Rate since 2000

Source: Eurekahedge

However when these assets are compared to the risk-adjusted ratios, it shows that multi-strategy and fixed income funds are the best picks in terms of risk-adjusted returns. Long/short equities, CTA and macro funds, on the other hand, are riskier which is consistent with the high level of volatility in the Latin American markets. This could also imply that in the coming few years, more money will be flowing into multi-strategy and fixed income funds, consequently slowing down the growth rate of the other strategies.


Fig 7: LATAM Onshore Average Asset vs Risk-adjusted Ratio

Source: Eurekahedge

A Closer Look at the Offshore Funds

Assets of offshore funds represent 70% of the total Latin American hedge fund industry, out of which distressed debt funds account for almost 50%. This is followed by long/short and fixed income funds, which make up another 35% of the industry.

Fig 9: Breakdown of Offshore Funds by AUM

Source: Eurekahedge


As far as investment styles go, long/short equity is the most popular, followed by multi strategy, distressed debt and fixed income, which represent a combined 83% of the total number of offshore funds.

Fig 10: Breakdown of Offshore Funds by Strategy

Source: Eurekahedge

Similarly, the asset growth rate chart shows that distressed debt, long/short equity, fixed income and multi-strategy funds are the most popular amongst investors.


Fig 11: LATAM Offshore Asset Growth Rate Since 2000

Source: Eurekahedge

The reason for this is evident in the table below, which shows the impressive performance of these strategies since 2000.

Fig 12: Performance of Latin American Offshore Funds
Strategy
Annualised Returns (%)2
YTD (%)3
2004 Returns (%)
2003 Returns (%)
Arbitrage
7.08
3.33
5.41
n/a
Distressed Debt
18.68
5.51
18.29
27.37
Event Driven
36.89
13.35
22.57
38.56
Fixed Income
15.56
5.58
11.07
23.85
Long/Short
11.82
5.97
17.62
54.76
Macro
15.17
2.63
6.59
40.03
Multi Strategy
13.75
4.22
10.95
22.98
All Strategies
15.37
5.55
15.26
36.75
Source: Eurekahedge

Comparing the risk-adjusted ratios relative to the average assets shows distressed debt, event driven, fixed income and multi-strategy funds as quality assets with high returns and low risks. Though long/short equity funds seem riskier than their peers, they continue to be able to woo investors due to their laudable performance.

Fig 13: LATAM Offshore Average Assets vs Risk-adjusted Ratio

Source: Eurekahedge

Performance Comparison

The index comparison chart below shows the extent to which the Eurekahedge Latin American Long/Short Hedge Fund indices have outperformed the MSCI Latin American Equity Index since 2000. It is notable that the Eurekahedge Latin American Onshore Long/Short Equities Index has been generating positive returns throughout 2000 to 2005, even during the period between Jan 00 and Dec 02 when the Latin American equity markets lost around 22% from its first quarter 2000 highs. During the same period, the Eurekahedge Latin American Onshore Hedge Fund Index registered a return of 20% while the Eurekahedge Latin American Offshore Long/Short Hedge Fund Index lost around 3%. The mean volatility in the returns for the long/short hedge fund indices during the same period was around 2.45% compared to the equity markets' volatility of around 8.2%.

Fig 14: Index Comparison

Source: Eurekahedge

Fig 15: Comparison of Wealth Creation
 
Eurekahedge Latin American Onshore Long / Short Equities Hedge Fund Index returns
Eurekahedge Latin American Offshore Long / Short Equities Hedge Fund Index returns
MSCI EM LATIN AMERICA Equity Index
Jan 00 - Dec 02
20%
-3%
-22%
Jan 03 - Dec 04
112%
82%
125%
Jan 05 - May 05
7%
6%
16%
Source: Eurekahedge

Correlation Stats

It is not surprising that the Eurekahedge Latin American Long/Short Hedge Fund indices have been tracking the local equity markets closely. Most of the long/short equities funds trade Brazilian and Mexican stocks; have a long bias coupled with lack of shorting opportunities due to regulatory bottlenecks.

A high correlation would imply that on one hand the hedge fund managers would be able to ride on the bull run of the equity markets but they could be in trouble if the market heads south. However a very low volatility of the long/short indices returns implies that the managers have the risks hedged to a good extent.

Fig 16: Correlation Table
Indices
Eurekahedge Latin American Onshore Long / Short Equities Hedge Fund Index
Eurekahedge Latin American Offshore Long / Short Equities Hedge Fund Index
MSCI EM LATIN AMERICA
Eurekahedge Latin American Onshore Long / Short Equities Hedge Fund Index
NA
0.779
0.815
Eurekahedge Latin American Offshore Long / Short Equities Hedge Fund Index
0.779
NA
0.853
Source: Eurekahedge

Lessons from Brazil and how do they apply to other regions4

This is not so obvious or easily applicable as offshore and onshore funds have innate characteristics; so do each of the specific countries in the region. A quick review of the numbers puts Brazil in the spotlight-market size of approximately US$400 billion as compared to Mexico's US$200 billion and Chile's US$100 billion. The number of newly-listed companies also brings attention to Brazil. Putting the numbers aside, each country has a distinct history on its monetary and fiscal policies and financial market liberalisation, which has either contributed to or hindered a capital market-focused culture.

Brazil and Argentina are synonymous with skilled traders. Argentina, however, in the aftermath of its financial crisis has witnessed an exodus of its talent to New York and other financial centres. At best, Argentine financial markets are in the incipient stage of recuperation. Lacking product and confidence, it is not likely that onshore funds will take off.

In Brazil, the explosive growth of onshore funds is two fold. In the first instance, the layoffs in investment banks supplied the skill set while alpha and diversification attracted high net worth and family offices. At the same time, the launch by Brazil's ex Central Banker in 2003 provided visibility and led considerable credibility to the asset class. However, it was the financial institutions "packaging" of the product to a retail clientele that propelled the growth of assets to the current levels. Even so, onshore funds in many respects are still at a nascent stage.

New funds should continue to emerge in Brazil, although at a slower rate and with higher barriers to entry. The appeal of managing a fund continues to gain traction as does the demand for managers with edge and capacity. A reduction in interest rates from their + 20% per year should also lead to future demand of equity style funds.

Pension funds are also lagging to participate as investors. Although not precluded from investing per se, they are not allowed to allocate to funds that short companies.

Regulation of the industry, in particular, should be a significant contributor to future growth. In addition to its principal role as "watchdog" of the financial markets, the CVM or SEC of Brazil became the responsible governmental body of onshore funds with an aim to protect investors. In particular its measures are designed to improve transparency of information and inhibit unfair practices as well as standardise the calculation of returns. One example as a result of CVMs vigilant role is that onshore funds are obliged to report funds' daily NAVs to investors.

Improved transparency and other CVM initiatives should strengthen infrastructure and provide pillars for growth for the industry as a whole. However, hedge funds that employ a long/short or market neutral strategy are capacity restrained due to the availability of shares to short. The process in Brazil is quite different from the US or Europe. In Brazil, the shares are registered via the CBLC in the name of the investor and not the broker. As such, the process to short shares is dependent on the fund manager actively seeking shares and managing the operational aspects of renewing contracts and guaranteeing availability to avoid a squeeze. Not only is the process laborious, the supply of shares to short is limited as for the most part pension funds and the BNDES are not willing to lend their shares. Fund managers need to employ significant resources and time to managing the process and building the relationship with the different brokers.

To note, it is the registered owner of the shares that hold the voting rights. As the shares may not be called back during the duration of the contract, the above groups are reluctant to lend their shares. This said, on average the cost to borrow in Brazil is 5% per year. When pension funds are no longer indifferent to 5%, that will be the decisive point in the development of onshore funds.

Conclusion

These are exciting times for the Latin American hedge fund industry, more so for the larger ones like Brazil and Mexico. The returns which the Latin American alternative funds have been producing, in particularly since 2000, have been unmatched by any other regions across the globe.

All these are positive signs for the Latin American alternative investment industry, which we expect is set for an explosive growth in the coming decade.

Footnotes

1The Latin American hedge fund industry comprises of funds either located onshore or having a Latin American investment mandate if located offshore.

2Annualised returns calculated since 2000

3Returns up to and including July 2005 NAVs

4The "Lessons from Brazil and how do they apply to other regions" section of this report is contributed by Claudio Andrade of Polo Capital Management. Claudio is based in Brazil. For further details, please visit www.polofund.com.

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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