Research

Emerging Markets – To Hedge or Not to Hedge

…that is the question, whether ‘tis safer in a bind to suffer the peaks and troughs - or pay outrageous fees hedging against a sea of troubles, and, by opposing, end them1?

Investing in emerging market hedge funds is a completely different activity from investing in emerging markets. Investing, unhedged, in emerging market securities, is a long-term bet on the growth of the corporate sector of the developing world, and, at points in the cycle, a shorter-term bet on the risk appetite of global investors. The following figure shows the roller-coaster ride that a directional emerging market investor would have experienced over the past ten years.


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Source: MSCI

Investing in emerging market hedge funds, on the other hand, allows an investor to benefit from the inefficiencies in developing capital markets and, therefore, offers a much more consistent investment over time.

The following figure illustrates a universe of emerging market hedge funds. Note (1) how the return pattern is generally much smoother than that of a long-only investment; and, in particular (2) through periods of extreme volatility but little net return in emerging markets (eg 1999-2004), the emerging markets hedge fund aggregate gave consistent positive returns.


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Source: Eurekahedge

When I started researching hedge funds in 1998, the ‘emerging markets’ bucket in most hedge fund indices consisted mostly of macro-type funds; these funds used their knowledge of emerging markets and emerging capital markets, to take directional bets on volatile and usually over-reacting markets. Currently, there are almost 800 Asian-dedicated hedge funds and about 250 Latin American hedge funds with a good number of Eastern European, Emerging Middle East and African, and global managers. There are volatility traders, fixed-income managers, short-biased managers, distressed and market-neutral funds. Patently, they are not all just betting on equity market directionality.

For example, GFIA Pte Ltd advises a fund of Latin American hedge funds. The Latin universe consists mostly of traders, who survived and prospered throughout their professional lives by trading through dislocations, currency devaluations, emerging market shocks, etc. Over time, they are anything but correlated to the direction of Latin capital markets or the health of the Latin American economies. They make money from distortions in investor perception and structural inefficiencies in their markets. Yet, as we present the fund to investors, we are continually being asked questions that focus clearly on the direction, health, cheapness and so on of the Latin universe. Managers make money from liquidity shifts, rapid changes in policy and the movement of asset prices against each other. They are not a factor exposure to Latin economies.

The following figure shows a composite track record of a Latin fund of funds (FOF) manager2 , plotted against equity markets, currency and fixed-income returns. Patently, the universe of Latin hedge funds is not a simple formula driven by the direction of the securities market.


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Source: GFIA

Similarly, GFIA runs a small Asian FOF. The mandate is explicitly to look for alpha without market correlation. While all the managers are physically located in Asia and trade Asia with all or part of their capital, the fund shows little or no correlation to capital markets.


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Source: GFIA

Clearly, investment in emerging market hedge funds can deliver returns that are divorced from emerging market directionality. However, in practice, many emerging market hedge funds in fact show some degree of correlation to their underlying markets. There are two reasons for this.

First, directionality makes money, sometimes reaping in so much money that the accompanying risk does not matter. Russia, a market that has risen 464% in US dollars over the past five years3 , undoubtedly saw great inefficiencies, but the arbitrage gains would have been so much eclipsed by the market’s rise as to be almost irrelevant.

Second, many emerging market inefficiencies are present due to illiquidity or information mismatch. They are therefore very susceptible to arbitrage capital using up available illiquidity, or highlighting the opportunity. Generally, therefore, there is an inverse relationship between pure alpha from inefficiency, should you want it, and capacity. I recently took umbrage at a presentation by a well-known global arbitrage fund manager who said: “We can’t invest in Asia because it’s impossible to hedge.” It turned out that what he meant to say was: “We can’t invest in Asia because it’s impossible to hedge US$3 billion with daily liquidity.”This statement is probably correct. Our research suggests that the ‘sweet spot’ for a classic Jones-model Asian long-short strategy (which will, by definition, also include some directional themes) is around US$300 million. The following analysis of over 300 funds and a four-year time horizon illustrates this4 :

 Annualised RORMaximum drawdownStandard deviationGain deviationLoss deviationSharpe 5.00%Sortino 5.00%
AUM 13.55%-5.39%5.90%3.86%2.41%1.372.79
AUM US$21-50m12.69%-4.19%5.76%4.12%2.08%1.262.52
AUM US$51-150m16.97%-6.02%7.32%5.38%2.61%1.523.31
AUM US$151-300m22.83%-5.24%8.85%7.18%2.40%1.835.20
AUM >US$300m19.38%-6.13%7.99%5.85%3.11%1.663.80
Note: AUM is asset under management.
Source: GFIA Pte Ltd

If a manager wants to be able to deploy substantial amounts of capital in emerging markets (and generally their compensation is of course largely determined by the size of the assets), the manager will have to run a strategy that accepts some level of directionality.

Another implication of the lack of scalability of alpha (non-correlated return) in emerging markets is that the larger players are at a distinct disadvantage. In emerging markets, while investors should, as usual, check the basic operational strength of a manager, as a general rule, it pays to allocate to smaller managers. This is because the larger the manager, the larger the trades they need to find – and the correspondingly fewer there are. Investors risk finding that the larger managers they invest with tend to have a fairly high cross-correlation, as they are often fishing in the same pond.

Thus, an investor has, in theory, a continuum between pure alpha and pure beta (as is the case in many markets), with both alpha and beta returns often being substantially larger in emerging markets than developed ones. However, these returns are highly scale-sensitive. While for a developed-market investment an investor may be better off with a big-name money management firm, this is unlikely to be true with regard to allocations to emerging markets.

This means that investors need to be more sensitive to operational risk if they are allocating to hedged strategies in emerging markets. To generate investment performance, investors are likely to invest in smaller organisations. Conversely, if investors confine themselves to larger organisations, they will likely lose performance. There is obviously a trade-off: if the cost of the additional work one needs to undertake (in the form conduct research and due diligence on a smaller organisation) outweighs the performance benefit, then there is no point. However, in focusing on emerging market hedge funds, as GFIA does, considerably more time is spent on organisational, people, operational and business risks by our managers, relative to our counterparts who look at developed market managers.

The figure below shows the asset size of the universe of Asian hedge funds. While a fund manager with assets totalling US$500 million or more could be considered to be a stable business (with management and performance fees, we would estimate that revenues at US$500 million of hedged assets should be approximately and conservatively, US$15 million pa), a fund of less than US$100 million of assets would be generating perhaps only US$3 million pa. Given that this has to support some level of professional headcount, systems, legal and professional services (and that the calibre of professionals capable of leading a hedge fund would be able to command very substantial compensation within an investment bank or large money management firm), this must be considered a borderline stable operation. Of the 518 of funds, 324 (63%) fall below the US$100 million bar. Some will have deliberately capacity-constrained investment strategies, and, therefore, the businesses will be resourced to be successful with small asset bases; some will form part of a ‘platforms’ sharing resources with other funds. But the fact is that allocators will often need to make a judgment call on the business, as well as the investment strategy.


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Source: GFIA

Operational and business risk is usually manifested in performance (the fund’s performance is hampered), but can lead to failure if assets do not accumulate or are withdrawn. In such circumstances, investors see at least the return of their capital. Generally, there has been little catastrophic risk in emerging markets managers, but it does happen. Fraud is the paramount business risk; it is very difficult to spot, but is clearly a catastrophic risk.

Most investors in emerging market hedge funds assume a higher tolerance for volatility than in their developed market hedge fund allocations. We believe this is appropriate. First, the inefficiencies of emerging markets make for less predictable returns (both in terms of size and timing). Second, the lower correlation of emerging markets with developed markets allows a tolerance for volatility (in a portfolio context, of course, uncorrelated volatility is good). Finally, the real risk of emerging market investing, both long-only and hedged, is tail risk or catastrophic risk; hence, an allocator not generating supranormal monthly returns is likely not to compensated, over the life of the investment, for that event risk.

Several global hedge fund houses have experienced disappointing returns from their Asian balance sheet, as developed-market risk management tools and mindsets have squeezed out return alongside volatility from their portfolios.

While a significant part of the overall risk of investing in emerging markets hedge funds is operational, there is also an investment risk as well. In GFIA’s eight years of researching and allocating to emerging market hedge funds, we have seen several patterns of catastrophic risk.

First, and possibly the most common, is when a carefully hedged strategy starts disintegrating. Truly accurate and complex hedges in emerging markets probably require special structuring, and this exposes the fund to counterparty risk (not necessarily of counterparty default, but of the commercial risk of having a very limited exit route). One sophisticated market-neutral regional arbitrage fund in Hong Kong was forced to return capital to investors when an over-the-counter counterparty refused to close out positions early at a market-related price.

The second pattern is driven by inappropriate leverage. While unusual – most emerging markets are inefficient enough not to require leverage to generate acceptable returns – this can be terminal.  A Japanese long-short fund that was leveraged three times imploded when some of its underlying positions moved against it during a period of very thin trading over the New Year.

The last pattern involves fraud. We have only seen deliberate malpractice ‘kill’ two funds in Asia in eight years, (and none in Latin America in two years). However, we are sure that as emerging market hedge funds attract assets, the overly entrepreneurial hedge fund managers will move in too; thus, fraud risk in emerging markets will inevitably increase.

It is of course therefore extremely important to do one’s manager research and conduct due diligence and monitoring. As all of these activities when undertaken in environments that may be very foreign to the allocator, will increase the cost of the allocation significantly, many allocators prefer to use the services of an FOF or a consultant to assist in their allocations to emerging market hedge funds.

Peter Douglas has over 21 years of experience in the investment management industry, gained in London, Singapore, Sydney and Tokyo.

He is principal of GFIA Pte Ltd (www.gfia.com.sg), a Singapore-based consulting firm, engaged exclusively in the research of hedge funds and their managers. Established in 1998, GFIA is Asia’s oldest hedge fund consultancy, compensated solely by fully disclosed fees from investors and allocators. Since 2004, GFIA has also offered coverage of the Latin American hedge fund industry.

Peter began his career spending ten years with the Foreign & Colonial group of asset management companies, including managing the product development of Latin American Securities (latterly F&C Emerging Markets), before setting up Aberdeen Asset Management’s business activities in Singapore, and working with Investor Select Advisors, a global fund of hedge funds, where he was responsible for research and allocation to Asian hedge funds.

Peter is the inaugural Council Member for Singapore for the Alternative Investment Management Association (www.aima.org), the global industry body for hedge fund practitioners. He was the inaugural honorary secretary and a founder of the Financial Planning Association of Singapore (www.fpas.org.sg) and remains special advisor to the association. Peter holds an honours degree from the University of Exeter, the United Kingdom, an Investment Management Certificate from IIMR, also in the United Kingdom and an MBA from INSEAD in France. He is also a pioneer-cohort Chartered Alternative Investment Analyst (www.caia.org).

Peter sits on the board of the CAIA Association, and is a member of the MBA Admissions Committee of INSEAD. He serves in a non-executive fiduciary capacity for a number of investment vehicles, is trustee and chairman of a Singapore charity, teaches masters’ students at Singapore Management University, and is a frequent media commentator on the industry.

Footnote

1 With apologies, of course, to Shakespeare’s great speech of weariness, emotional exhaustion and nihilism.

2 The Composite FOF is the track record of one fund manager managing two successive funds with comparable though not substitutable mandates.

3 MSCI Russia end-July 2001 to end-July 2006.

4 GFIA Monthly Client Note May 2006.

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