The objective of this article is to provide a general assessment of the new but rapidly-growing hedge fund industry in Latin America, identifying the key growth drivers from both supply and demand sides. We briefly examine the market environment and how the industry has evolved in recent years. Also, this article aims to give an overview of the industry including strategies, location, size, organisation/people, specific characteristics of the local industry, and some thoughts on possible future developments.
We hope that an introductory analysis would answer some of the questions that allocators might have, given the current lack of information about this region, which ultimately is very attractive from a diversification and return perspective.
Latin America accounts for 7.6% of the world's PPP-adjusted GDP1 and 8.2% of the world's population2. But its capital markets are bigger than those numbers would suggest. Some Latin assets/instruments, notably fixed income and derivatives, are very liquid - according to an EMTA survey3, more than US$520 billion of Argentinian, Brazilian and Mexican debt instruments (including local instruments and eurobonds) were traded in the 1Q04, which is equivalent to a daily turnover of approximately US$8.4 billion.
Similarly, it's not an exaggeration to say that Latin America is still an under-represented region in the global hedge fund industry. With an estimated US$18 billion of assets4 and 222 hedge funds, it represents only 2.2% of the total universe5.
The majority of Latin hedge funds are focused on Brazilian markets, and Brazil is where most of the assets and managers are. Among the various causes of such dominance are the highly-developed local banking and mutual fund industries (ICI estimates that Latin mutual fund industry amounts to US$215 billion of assets - Brazil accounts for 80% of the region's total and that in turn is equivalent to 60% of Brazilian GDP) as well as the micro-structure of capital markets and high reliance on debt as a financing alternative, especially after the Brady Plan debt restructuring in the early 1990s.
Argentina-focused hedge funds suffered a big hit in 2001 (devaluation + default) - less in terms of underperformance but rather because of the absence of liquid securities to trade. In the aftermath of the default, analogous to what happened in Russia after the ruble devaluation and default, we saw a couple of investment teams setting up hedge funds or quasi-private equity funds to take advantage of the debt restructuring process and the extremely low price levels of Argentinian assets.
After its upgrade to investment grade (1Q2000), Mexico decoupled from the rest of the region. Currently it can no be longer seen as an integral part of the Latin American hedge fund community, even though Mexican bonds and currency are widely traded by hedge funds.
As in the case of Argentina, in Mexico, the local mutual fund industry is relatively small and that is actually a compelling argument to explain the scarcity of pure Mexican/Argentinian hedge funds. As a matter of fact, the natural career path for the more talented Mexican and Argentinian traders has been to join the big investment houses in New York rather than the local banks. In this respect, the Brazilian experience is totally different, since the local investment banks and local branches of the foreign banks retained (and formed) most of the traders who ended up managing their own hedge funds.
The breakdown of assets and managers per geographical coverage is shown in the table below:
|assets US$m (a)||no. of funds (a)||no. of managers||avrg assests per manager|
|Brazil - Onshore||16,145||189||89||181.4|
|Brazil - Offshore||1,000||13||11||90.9|
|Gobal Emerging Markets (b)||7,675||49||35||219.3|
Sources: Fortuna (for Brazilian onshore funds; www.fortuna.com.br), EurekaHedge(www.eurekahedge.com), CogentHedge, Hedgefund.net. Analysis/estimates by GIFA (www.gifa.com.sg). (a) the assest size and number of funds resulted from GIFA estimates. There are no official classification nor definition of what is a hedge fund and, therfore, the estimation was made on th basis of the previous experience of the author of this article as well as of the definition of investement mandle and investment style provided by someone of the managers. (b) do not inculde emerging markets hedge fund that have exclusive focus in asia and/or Eastern Europr/Russia
The other hedge funds with active participation in the region are either a) funds that exploit the whole set of Latin markets, typically with a heavy weighting in Brazil and Argentina; these funds have in aggregate around US$825 million of assets or b) funds that oversee the entire emerging markets universe, where Latin America has a significant weight (on average 40-60%) depending on whether the fund is biased towards equities or debt - though in the former case, Asia probably has a bigger weight than Latin America. Excluding those funds that clearly have an exclusive investment mandate for Asia and/or Eastern Europe/Russia, global emerging markets hedge funds have in total an estimated US$7.7 billion of assets.
As we will examine in more detail in this article, the industry is relatively new but is fed by strong local demand, a good supply of skilled professionals, and numerous trading opportunities.
Latin capital markets offer good liquidity, depth and volatility - a fruitful environment for hedge fund managers. Notably, the most liquid markets are fixed income (cash, bonds and derivatives), either onshore or offshore, with relatively long yield curves (up to 30 years in Brazil and Mexico), with a variety of other assets and their derivatives.
Currencies. Latin currencies are still not fully convertible, but with a few exceptions6, there is good liquidity in spot and forward markets (Chilean peso and Brazilian real NDFs trade more than US$700 million/day7) and in currency-linked derivatives markets in organised exchanges such as BM&F in Brazil, as well as liquid OTC markets. Also, it's important to note that all Latin currencies now follow a floating regime which significantly reduces the chances of having major devaluation events.
Equities. Large caps are liquid, especially ADRs traded in the US. For some Latin names, turnover of ADRs surpasses that of locally traded stocks by a high margin8. Also, the restructuring and consolidation that took place after the privatisation cycle opened doors for event-driven plays and capital structure arbitrage.
Derivatives. Local futures and derivatives exchanges are very liquid; some are among the most liquid in the world. The most traded contracts are local interest rate and FX futures and options at BM&F in Brazil, local debt and Mexican peso futures in Mexico, soft commodities in BM&F, equities/index futures and OTC credit derivatives (more than US$60 billion of Brazil, Mexico and Venezuela credit derivatives were traded in 20039).
The inception of the hedge fund industry in Latin America was a by-product of the economic stabilisation plans that mitigated hyperinflation in Latin America from the 1990s. This is not a coincidence: without a minimum set of functioning institutions, economic/political "normality" and stability of rules, there is not enough solid ground for the development of hedge funds or any other sophisticated investment. The first local Latin hedge funds appeared in Brazil in mid-1990s, after the successful implementation of the Real Plan.
We can identify three major watersheds for the hedge fund industry:
- The end of hyperinflation in the early 1990s and growth of influential local investment houses, notably well developed investment banks with very aggressive risk appetite. At that time, there weren't many independent hedge funds as we know today, but the proprietary trading desks operated as true hedge funds, having a relevant impact on prices and volumes. There was also a relevant technology transfer from the US/foreign banks to the local shops;
- The aftermath of Asian and Russian crises (1997/98): consolidation of hedge fund and mutual fund industry and strengthening of the banking system which led to an overall reduction of leverage and systemic risk in the financial system10.
- The dismantling/retrenchment of foreign investment banks' operations in the Brazilian pre-election (2002) which triggered a new harvest of managers, most of them ex-proprietary traders
After 1999, growth rates in terms of assets and number of managers picked up. Currently, there are approximately 120 managers fully dedicated to Latin America, and around 35 managers that cover the whole emerging markets opportunity set and hence have a significant exposure to Latin America. It is a new industry: at least 50 out of 120 managers set up their businesses after 1999.
Another important factor driving the industry growth is the gradual reduction of real interest rates - more pronounced in the last two years. The decrease of expected returns on fixed income in addition to the poor returns of the equity markets made both high net worth individuals and institutional investors shift a substantial part of their wealth from traditional long-only investments to hedge funds - in Brazil, for example, there is an additional incentive for institutional investors to invest in onshore hedge funds since they are not allowed to invest abroad (as compared, for example, with Chilean pension funds11 , who are big offshore investors).
Most hedge fund strategies are represented in the region. Some of them, however, such as convertible arbitrage, event-driven and options arbitrage, are sub-strategies within hedge funds but are not represented as dedicated stand-alone hedge funds.
The reason for this gap is structural. Besides the lack of liquidity, and variety of available instruments to trade, we must take into account the nature of the Latin markets. The perennial high volatility in the last few years has helped to exacerbate the economic cycles, and certainly accentuated the "strategy cycles". In other words, in a volatile market such as Latin America, the strategy-cycle is more volatile and changes more frequently than in developed markets.
From a hedge fund manager's point of view, the most efficient way to capture the constantly-changing opportunities in the region is to have a flexible investment mandate (multi-strategy and macro) that would enable the manager to utilize whatever strategies are providing better opportunities at any given period of time.
From an allocator's point of view, that requires a closer monitoring of the local markets in order to identify the strategies that would offer abnormal profit opportunities at an acceptable level of risk.
Out of the universe of 222 hedge funds, we estimate that roughly 50% are multi-strategy funds, with a strong bias towards macro trading. These and the stated macro 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.
Fixed income arbitrage managers tend to focus on the more liquid fixed income markets, notably by focussing on yield curve trading, interest rate spread trading and credit spread trading (mostly with sovereign debt). As their G7 peers, they do employ leverage to maximise their returns, but the typical gearing is probably around 3-5x NAV which is low compared to similar strategies in the more developed markets.
There are a significant number of managers who trade distressed securities - we saw an upsurge of such managers after the multiple credit events in the region (default in Argentina and Ecuador, devaluation in Venezuela, Brazil). Distressed debt managers mostly trade debt instruments; as opposed to Asia where managers are basically positioned in floating rate and loan-based assets, Latin distressed managers predominantly trade fixed rate bond-type instruments.
Long-short equities managers can be roughly divided into two major sub categories: a) directional (Jones-model), with fairly concentrated portfolios, relatively small balance sheets (it's quite unusual to see managers with gross exposure higher than 120-140% NAV) and sometimes very active trading; b) market neutral - though neutrality is a controversial topic (and particularly difficult to measure in less efficient markets), this group gathers managers who emphasise pairs trading, either intra or cross sectors with low net exposure (typically, around +/- 20% NAV).
Finally, we should not forget the small but representative number of managers that are based in the region but who have a global mandate. These are essentially macro managers that have a small bias towards Latin America (say, a 0% to 20% exposure in Latin America, the rest is global) but trade globally, both in G7 markets and in the other emerging markets.
The majority of managers are locally based: Brazil (Sao Paulo, Rio de Janeiro) and Argentina (Buenos Aires) are the major centres. Outside Latam, New York and London attract important names of the industry mainly because many of the former emerging markets traders/portfolio managers were traditionally located there. From the late 1990s, many of the dedicated country trading desks in the big US/European banks were shut down and more generic Latin trading desks were set up instead - as a consequence, many traders left the banks and increased the supply of well-trained professionals with Latin expertise.
Among the non-obvious locations, we would include Miami (midway between NY and Latam) and the US West Coast. We do not think that it is critical to be in loco to stay in the information loop and have a better assessment of the markets. Offshore managers are in a position as competitive as their onshore/local peers. However, the major drawback of being located offshore is that for an industry driven by local demand, offshore products cannot capitalise on the local investor base.
Size varies across the spectrum of strategies, but macro funds are visibly larger than the other strategies.
The larger funds can be found in the macro space (as large as US$300-500 million; average size of US$110 million) whereas the equity-linked strategies (long-short, event-driven) and multi-strategy funds fall within a smaller interval (larger funds typically have US$20-30 million). Relative value hedge funds have a similar size.
Fixed income arbitrageurs have also a reasonable amount of assets: funds within this category have on average US$93 million.
|Average Size( US$m per fund) (a)|
Sources: Fortuna (for Brazilian onshore funds; www.fortuna.com.br), EurekaHedge(www.eurekahedge.com), CogentHedge, Hedgefund.net. Analysis/estimates by GIFA (www.gifa.com.sg). (a)the assest size and number of funds resulted from GIFA estimates. There are no official classification nor definition of what is a hedge fund and, therfore, the estimation was made on th basis of the previous experience of the author of this article as well as of the definition of investement mandle and investment style provided by someone of the managers.
An important side comment is that global emerging markets hedge funds are usually larger than their Latin peers - they are on average four times larger than the latter. This phenomenon makes logical sense given that the opportunity set in the global emerging markets is much wider than that of Latin America, although we also recognise that in terms of volumes and market cap, Latam perhaps represents more than 40% of the global emerging markets set.
The minimum size needed to have a minimally scalable business is around US$10-15 million. Assuming that managing firm revenues oscillates around 100-150 bps from management fee, and 10-20% of performance fee, that would be enough to cover both business costs and maintain the staff without having to add more working capital to the business (Mercer, a consulting firm, estimates that living costs in Latin American major centres are half of that of NY12).
On the other hand, only a few funds have faced problems from being too big. We estimate that fewer than 10% of the managers in the region are either soft or hard closed. There is still capacity and potential allocators should find good managers capable of accepting new money.
The more pronounced bottleneck seems to lie on the equities side: notoriously, liquidity in Latin equity markets is "stuck" in few names, with the few top traded stocks concentrating a disproportionate share of the total turnover. Arguably, the less liquid instruments are mid/small caps and corporate bonds (debentures, bonds and loans).
Even so, there is no such deep capacity problem as we witness in the more developed markets. There is enough liquidity, variety of traded instruments and more important, volatility. Higher volatility actually allows managers to keep relatively small balance sheets and not a great deal of leverage in order to get very acceptable returns.
Organisationally, the average Latin hedge fund is not dissimilar to its US, European or Asian peers. Hedge funds are normally managed by a small advisory firm, owned by three or four principals, where normally the investment side is segregated from the operations and client side.
Since most of the managers had previous experience on Wall Street investment houses or well-established proprietary desks, professional training and skill sets are of a global standard. From a strict investment perspective, managers usually know what they're doing.
However, as is the case everywhere, the transition from a prop desk for a hedge fund business is not painless and carries some obstacles.
Additionally, more than 50% of failures of hedge funds are due to operational problems13. Latin America is no exception, and there have also been cases of intentional and unintentional mispricing, mishandling of assets, non-compliance with investment mandate, and absence of proper compliance which led to the termination of some hedge funds. Mortality rates are roughly the same of those of developed markets.
Therefore operational risk is a critical issue in Latam as anywhere, exacerbated by the relative youth of the industry. Any allocator should as always pay close attention to how the hedge fund is structured, how staff are incentivised, how efficient and effectively utilised are the risk management systems, and how sound is the compliance framework.
In terms of service providers, most of the offshore and onshore hedge funds utilise the bellwether administrators and custodians, both local and foreign names. For the Brazilian onshore hedge funds, the only potential wrinkle is the concentration of the administration services in the two largest players - although this does not represent an immediate threat, it may cause discomfort in case any of the hedge funds blow-up, raising concerns about systemic risk and contagion effects.
Characteristics specific to Latin hedge funds
Latin hedge fund managers trade in a region where markets are inherently inefficient. We believe that the sources of the inefficiencies in local capital markets and the subsequent volatility will remain relatively intact even if substantial money flows go into hedge funds.
Most importantly, the volatility that derives from the market inefficiencies makes leverage less crucial for Latin managers as it is for some managers trading in the G7 markets.
In fixed income arbitrage, for instance, the average hedge fund builds positions equivalent to 2-5 times NAV in order to capture opportunities in the local or offshore yield curves, a leverage substantially lower than that of a typical G7 arbitrageur. The flipside is that whereas leverage is lower, volatility is higher which means that the fat-tail risk is still present anyway.
Another particular aspect of demand for hedge funds in the region is that the transition from traditional investments to hedge funds occurred in a more abrupt way than in other parts of the world. A possible explanation lies in the scarcity of really good active fund managers in the region - this is especially true for the equities universe: most of the active funds are merely enhanced index funds and it's relatively difficult to find funds that consistently delivered alpha.
Access was also a facilitating factor for this shift - the large number of onshore hedge funds particularly in Brazil facilitated the access to hedge fund.
Before diving into details, we have to bear in mind that in terms of regulation, onshore and offshore funds belong to very distinct universes.
Offshore funds have the same degrees of freedom as the more well-known US and Europe offshore hedge funds. Their legal structure follows the "standard" of their US/European peers - they are normally constituted as mutual fund companies or investment companies in Cayman Islands, Bermuda or BVI, and have the investment advisor based in Latam or in the other obvious locations. They are flexible investment vehicles. The only additional risk to be taken in account is the convertibility risk for the portion of assets that is onshore in order to buy local assets or to margin trading activities in the local exchanges. As for the margin, it is rarely a significant amount of assets, since the typical haircut is not different of that of developed markets.
An important difference that exists between Latin offshore funds and their peers though is that in terms of corporate governance, it is still unusual to have independent directors for the fund.
Onshore hedge funds, especially in Brazil (where the most of onshore funds are), have a very well-conceived regulatory framework in the beneath, which may be a surprise to many people. The large majority of onshore hedge funds have daily liquidity (with redemption payment from 1 to 4 working days); even those few that have monthly liquidity, report daily NAVs. Onshore hedge funds are under the same legislation applicable to mutual funds, but with amendments accounting for specific issues related to hedge funds (such as use of leverage, whether the fund can have negative NAV due to losses, etc). The Brazilian securities commission (CVM) supervises the whole mutual fund industry which includes hedge funds and monitors the hedge fund leverage and portfolios on a daily basis14.
So, in summary, we can say that an allocator may have the same concerns when investing in a Latin offshore fund as compared to an US/European offshore hedge fund. Neither less nor more. As for onshore hedge funds, a potential allocator should pay more attention to the convertibility risk whereas the regulatory risk and systemic risk (due to over-leverage of hedge funds and/or non-adherence to the mandate) do not represent material reasons for concern (and are arguably less of a risk than comparable funds elsewhere in the world).
Opportunities, risks and future developments
We see the combination of 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 is explained by the larger number of onshore hedge funds in Brazil. We could thus expect a further internationalisation of demand which is one of the main challenges to be faced by the industry. That would require more offshore vehicles to receive allocations from the larger international pots of money (private banks, funds of funds). As briefly examined in this article, the investment risks are comparable with those embedded in investing in hedge funds in the developed markets.
For allocators in general, the region offers an interesting opportunity of investing in highly skilled but relatively unknown managers. It is a particularly attractive region in having spare capacity and growth potential. Hedge funds are probably the best investment alternative to benefit from the opportunities in the region, using relatively low leverage and being less sensitive to the cyclicality that is characteristic of emerging markets.
Latin America is also a potential source of demand for G7 hedge funds. According to recent research 15, Latin America is one the most prolific producer of high net worth individuals (double-digit annual growth rates) and the highest average wealth per HNWI of any major region (US$12.5 million per high net worth individual, compared to less than US$5 million in the rest of the world).
We see the increase of allocation of Latin investors into G7 hedge funds as beneficial for both investors and Latin hedge fund managers - the technology spillover and knowledge transfer effects are relevant and might accelerate the internationalisation of the Latin hedge fund industry.
On the supply side, we believe that the supply of new managers will continue to be sourced by local talent. The entry barriers for managers that do not have local knowledge (including not being locally based) are high. The successful non-Latin managers are the ones who have been trading in the region for a long time and as such have already climbed the learning curve, or rely on locally-raised professionals. Language is not a critical barrier, but knowledge of local markets is.
If the internationalisation of the hedge fund industry occurs (as we fully expect it will), we should expect the growth of more niche strategies managers as well as a more professionally developed local fund of funds industry, with the emergence of specialised fund of funds products (e.g., single strategy) and structured products.
Singapore, 28 July 2004.
This author would like to thank Peter Douglas, GFIA founder and principal for his comments, suggestions, and contribution to the scope of this article, and Francisco Camargo, owner of Fortuna, and Eurekahedge for access to their databases.
Enio is a principal of GFIA, and has built his career on constructing and managing funds of hedge funds. Enio was one of the partners and a portfolio manager at Hedging-Griffo (the largest Brazilian hedge fund group), managing one of Latin America's first funds of hedge funds. He then worked as a portfolio manager at GP Investimentos. Enio holds a B.A. in Business Administration from FGV and an MBA degree from INSEAD.
|GFIA pte ltd||www.gfia.com.sg|
|Member of AIMA||The Alternative Investment Management|
1 IMF - "World Economic Outlook", Apr 2004.
2 2003 CIA World Factbook
3 Emerging Markets Traders Association, EMTA Survey, June 2004
4 GFIA estimate
5 ifferent sources provide different figures for the total hedge fund universe. Those figures range between US$750 and US$1,000 billion of assets and 5,000-8,000 of hedge funds (sources: TASS, VanHedge, Eurekahedge, HFR).
6 6There are capital controls in a couple of countries in the region, such as Chile (quarantine), Ecuador and Venezuela.
7 EMTA, April 2004
8 Many companies that issue ADRs are actually trying to add more liquidity to their stocks instead of using the US equity markets as a source of funding.
9 EMTA, May 2004
10 PROER in Brazil and ample privatization programs of public-owned banks in Brazil and Mexico.
11 The US$38 billion of Chilean pension funds may allocate to offshore assets and from the 3Q2003, they are authorised to invest in offshore hedge funds as well (source: MAR Hedge, Oct 2003).
12 Mercer HR Consulting - "Worldwide cost of living survey", June 2004.
13 "Valuation issues and operational risks in hedge funds", Capco, 2004.
14 The administrators of onshore hedge fund managers send to the supervisory authorities the fund's daily positions, via Internet. The portfolio composition of each fund is available for any interested person on the Internet with a delay of some weeks.
15 "Valuation issues and operational risks in hedge funds", Capco, 2004.