The hedge fund industry in Latin America has witnessed tremendous growth over the last few years in an environment of favourable economic conditions and markets that are increasingly resilient to turbulence in the global economy; industry assets grew at a compounded annual rate of 50% in the last two years alone, while turning in some of the best returns among hedge funds globally (the Eurekahedge Latin American Hedge Fund Index has almost tripled in value since the turn of the century). Based on the information contained in the 2006 edition of the Eurekahedge Latin American Hedge Fund Directory and other related information, we currently estimate the total size of the Latin American hedge fund space at about 300 funds managing over USD40 billion in assets. The industry’s share of global hedge fund assets now stands at 3%, up from 1% at the end of 2000. Figure 1 below gives a snapshot of the industry growth over the past decade.
This review is broadly structured to inquire into some of the key aspects of the industry as they affect its participants, namely hedge funds and their investors. The section on hedge funds examines such salient features of the industry as fund size, geographical spread, attrition etc and their impact on the afore-mentioned growth and performance, while the section on investors takes a closer look at the cost (ie incentive fees) and accessibility (ie redemption preferences) of the returns generated.
Latin American Hedge Funds
Manager Location – Onshore vs Offshore
The hedge fund industry in Latin America saw two distinct phases of growth; the first was in the late 1990s, as wealthy local investors sought opportunities in the highly volatile regional markets. The majority of these onshore funds were (and continue to be) multi-strategy funds (refer to Figure 10 for a breakdown of assets in onshore funds by strategy) that were keen on protecting their capital in the face of turbulent markets.
The second phase of growth was fuelled by offshore funds (typically facing fewer regulations, thereby attracting global investors) as the general economic downturn in the region in 2002 made its markets rather attractive to opportunistic players, triggering significant inflows into the region as managers with a global and/or emerging markets mandate reallocated their assets away from the emerging markets in Asia. This trend is clearly discernible in Figure 2 below, with a marked upturn in the assets as well as the number of offshore hedge funds in 2003.
A significant number of the offshore managers are based out of Europe and the United States, with the United Kingdom alone housing nearly half of them, as shown in Figure 3 below. And given their branching out into more specialised strategies, offshore funds have been able to generate better returns over the past few years (refer to Figure 4).
Figure 3: Market Share (Offshore Funds) by Head Office Location
Furthermore, new hedge fund launches are increasingly being taken up by managers currently allocating to the region, rather than by new entrants, as indicated by Figure 5 below. This suggests that as fund managers hone their expertise in the region’s markets, fund portfolios are diversifying into more esoteric strategies as new opportunities emerge.
Comparing the original and current sizes of funds launched between 1996 and 2005 (Figure 6) lends further support to the claim that the year 2002 marked a surge in hedge fund driven liquidity in the region. The funds that made the biggest leaps in asset growth were, unsurprisingly enough, those launched in 2000 and 2001 – the years immediately preceding the up-tick in inflows.
By contrast, newer funds have not seen nearly as much capital appreciation by a long margin. A scatter plot of hedge fund returns during their respective initial 12 months (Figure 7) isolates the reason for this: between the state defaults in Ecuador and Argentina in 2000 and the market downturn in Brazil in 2002, hedge funds could capitalise on an array of special situations, which explains the superior performance (and tighter dispersion of returns) of funds launched between 2001 and 2004 as compared to those launched in 2005 amid buoyant regional equities.
Figure 8 inquires into the relationship, if any, between the size of a fund and its performance. It plots the average annualised performance of 225 Latin American funds of varying sizes, over the past 3, 12, 24 and 60 months up to and including Oct 2006. The rationale behind this is to spot any changes in the distribution of returns by size. For instance, comparing average performance over the last two years with that over the last five years, smaller funds (< USD500 million) had a far better run between 2002 and 2004 (which boosted their annualised returns over the five-year period), whereas returns of bigger funds (USD501 million to USD1,000 million) were actually pulled down. The pattern of returns over the past two years, however, suggests a general trend of no clear correlation between fund size and performance for a small-sized fund (< USD500 million), but as a fund grows bigger, there are diminishing marginal returns to be had beyond the USD1 billion mark.
In terms of strategies employed, as elsewhere explained, the majority of onshore funds are multi-strategy funds (accounting for 62% of total assets), while assets are more equitably distributed among offshore funds (Figures 9 and 10). That said, long/short equity funds are increasingly gaining currency among both onshore and offshore managers (currently accounting for two-fifths of total assets in either case), as equity markets in the region have begun to benefit from the surge in liquidity and the healthy consolidation trends in several sectors.
Another salient feature of offshore fund allocations among strategies is the prominence of debt-based strategies. Asian hedge funds, which have traditionally attracted equity-focused investing, offer a good point of contrast. Long/short equity funds form nearly 60% of the assets invested in Asian hedge funds, whereas debt-based strategies such as fixed income and distressed debt make up less than 10% of total assets. On the other hand, assets in debt-based strategies add up to a good quarter of offshore hedge fund assets in Latin America.
Figure 11 below traces the historical changes in the region’s hedge fund strategy mix over the years, with the balance being made up by multi-strategy funds. Multi-strategy funds now form just about one-third of all Latin American funds
(in contrast with 50% five years ago), and are gradually giving way to specialist and opportunistic strategies such as long/short equities, event-driven and relative value plays. Also, most of the larger regional economies are buying back their debt in the light of significant balance-of-payments surpluses. With receding foreign debt and credit spreads at an all-time low, there is now more interest in local currency debt and equity markets.
And finally, Figure 12 compares the performance of Latin American hedge funds across strategies, over the past five years. Returns across strategies have largely remained consistent with event-driven, multi-strategy and long/short funds generating upwards of 15% annualised returns. The notable exception is CTA/managed futures funds, which have experienced a downturn in the last three months to one year.
The broadening scope of opportunities in Latin America is a discernible theme on an analysis of the geographic focus of hedge funds as well. While the region-specific allocations of onshore funds are a given, offshore funds too are making inroads into country-specific investment avenues, as can be seen from the emergence of Brazil- and Argentina-focused funds. Figures 13 and 14 give the current size of allocations in the region (for instance, Figure 13 tells us that 58% of the assets of offshore funds parked in the region come from funds allocating to the ‘emerging markets’1 , while another 34% come from those with a ‘global’1 investment mandate).
Figure 13: AuM Share (Offshore) by Geographic Mandate
Figure 15 further buttresses the case for expanding markets, by looking at the shares (of total number of funds) of each of these geographic mandates over the past six years (the remainder being made up of funds allocating to Brazil). There are two aspects to this changing investment landscape: a) funds allocating specifically to Latin America have doubled their share of total funds in the region (from 3.5% in 2001 to the current 7%), while those with an ‘Argentina’ focus now form 1% of all Latin American funds (up from virtually none three years ago); b) funds allocating to the region as part of a broad ‘emerging markets’ focus, are losing ground to region-specific funds (‘emerging markets’ funds now form only 27% of all Latin American hedge funds compared to 37% in 2001); and c) funds with a ‘global’ mandate are increasing their Latin American allocations (‘global’ funds now make up 23% of all funds as opposed to 13% five years ago).
To test whether this shift was supported by the superior performance of Latin America focused funds, we annualised and compared the returns across regional mandates, over the past 3, 12, 24 and 60 months. This is depicted in Figure 16 along with the respective sample sizes used in the comparison. While Brazil remains the best-performing region over the past five years, the more recent returns (note the line graph for ‘Last 2 years’ performance’) of Brazil, Argentina and Latin America focused funds have clearly outperformed ‘global’ and ‘emerging markets’ funds with only partial allocations to Latin America.
The rate of attrition is another good measure of an industry in its ‘growth’ phase. In this section, we look at attrition rates in the Latin American hedge fund space from two angles: 1) which funds became obsolete; and 2) when they became obsolete (with a shorter life span serving as a proxy for poorer performance). Figure 17 achieves the former by comparing the number of funds (both launched and dead) by year of launch, while Figure 18 takes on the latter by comparing Latin American funds that were operational for less than one year against other such funds in Asia, Europe and Latin America.
Figure 17 simultaneously shows two aspects of the growth in the Latin American hedge fund industry – progressively more launches and a corresponding spurt in the number of dead funds – signifying a rush of entrants into the market. Also of note is the fact that the spikes in the number of dead funds correspond with the changes in the economic landscape that triggered the growth in the first place (years 2002 and 2003 in the graph).
Figure 18 compares funds that have operated for less than one year before becoming obsolete, across hedge funds in different markets. The fact that all of the funds that died within one year of their launch (irrespective of the markets they chase), were launched in or after 2001, is an indicator of the flurry of new entrants globally. This explains the spikes in the number of dead European and North American funds, as newer funds struggle in an environment of limited opportunities. In Asia, on the other hand, heightened launch activity (owing to the attractiveness of the region’s markets since the turn of the century) coupled with obstacles to capital-raising (investors’ money tended to chase only a few well-known funds) led to the increased numbers of short-lived funds over the last five years. With the wave of growth seen since 2003, Latin American hedge funds too seem to be at the incipient stages of a similar predicament.
Although nearly four-fifths of the sample hedge fund data set charges an incentive fee of 20%, the average incentive fee charged by Latin American hedge funds equals 19.5%2. Developed market funds tend to charge slightly more than their emerging market peers (the average for European and North American funds stands at about 19.75%, while that of Asian funds is nearer to 19.4%). This has partly to do with the high levels of launch activity in emerging markets, with start-up funds not being able to command as much in fees as well-established players in developed markets. This inverse relationship between incentive fees and performance seems to specifically apply to Latin American hedge funds as well (Figure 19), for similar reasons.
Figure 19 plots the annualised return generated over the past 3, 12, 24 and 60 months per percentage point of incentive fees. Fees are categorised as ‘below 20%’, ‘20%’ and ‘above 20%’. To illustrate, a fund generating a 40% annual return to investors after charging a 20% incentive fee, would mean that every percentage point of fee translates into 2.5 percentage points in total returns.
As can be seen from Figure 19, over a five-year term, this ratio was relatively flat. But during the more recent two-year term, with the expanding selection of fund offerings, funds charging above or below 20% have outperformed those charging a flat 20% fee.
In this section, we compare hedge fund returns over the 12-month period ending Oct 2006 across investment regions as well as investment modes, to see how Latin American hedge funds match up against their peers. To that end, Figure 20 below depicts the 1st, 2nd and 3rd quartiles and the mean of the last 12 months’ return of various alternative investment vehicles3, as well as a benchmark equity index – the MSCI EM Latin America Equity Index. In Latin America, for instance, we took all the funds’ annual returns over the past 12 months (from Nov 2005 to Oct 2006) and ranked them in ascending order. The bottom 25% (ie the 1st Quartile for Latin America in the figure) returned over 10% for the year.
Several interesting points emerge from this comparison. For one, all funds have means (ie average returns) that are greater than their median returns (ie middle values). This is typical of hedge fund returns, which usually display positive skewness, ie a greater concentration of data on the positive end of the return spectrum.
Another point to note is the significant difference in inter-quartile ranges (difference between the positional values at the 25% and 75% marks, ie between the first and third quartiles) between Asian and Latin American hedge funds and absolute returns funds on the one hand, and North American and European hedge funds on the other. Simply put, 50% of the respective data points for each type of fund fall within these inter-quartile ranges. That is to say, an investor choosing to park his money in an arbitrarily selected European fund would have a 50% chance of making a return of anything between 4% and 17%, whereas investing the same money in an equally arbitrarily chosen Latin American hedge fund would fetch him over 12% annual returns, 75% of the time.
And lastly, long-only absolute return funds have had a terrific year because of persistent bullish trends for a significant part of the last 12 months.
To summarise, the Latin American hedge fund industry has seen not only tremendous growth but also impressive returns over the past four to five years. While assets in Latin American hedge funds still make up only about 3% of global hedge fund assets, the region is quickly turning into the next major destination for investors and funds seeking absolute returns. Average fund sizes have increased nearly three-fold since end-2003, to over USD140 million, while the Eurekahedge Latin American Hedge Fund Index4 has risen by 80% over the past 36 months. As the regional industry grows, the trend among hedge funds is towards specialisation, in geographic as well as strategic focus, and away from broader ‘emerging markets’ and ‘multi-strategy’ mandates. Added to this are favourable economic conditions and resilient markets. The region has witnessed a spate of external debt buy-backs by regional economies benefiting from historic balance-of-payments surpluses. This is, in turn, shifting the focus of the regional investment landscape towards equity and local currency debt markets.
Taking a closer look at Brazil – the key financial market in the region and constituting the bulk of regional hedge fund allocations – contrary to the current global inflationary pressures, nominal Brazilian interest rates have recently dropped to below 15% as the central bank continues to pursue a loose monetary policy, suggesting a slowdown in inflation. Indeed the markets have already priced this in. The fall in interest rates spells continued flows of liquidity into the Brazilian markets, which in turn will favour hedge funds allocating to the region.
1These refer to ‘emerging markets’ and ‘global’ funds that have partial allocations to Latin America.