In contrast to how hedge funds evolved elsewhere, and in particularly in Asia, in Latin America the dominance of fixed income and debt markets explains the creation of many macro and multi-strategy funds, in detriment of other strategies, including equity long/short.
That is beginning to change.
In the last 18 months, we have seen an increase in the number of new long/short managers setting up in the region. Among those funds, it is possible to identify classic Jones-model funds, funds with low net exposure, and funds which emphasise pairs trading. Contrary to how this industry looked like a couple of years ago, now there is enough diversity in terms of style and it is no longer a group of quasi mutual funds which simply protect part of the long book by shorting the index.
Currently, there are roughly 301 equity long/short funds with a 100% focus on Latin American markets. In addition to that, there are at least 25-30 managers who cover global emerging markets and thus keep a reasonable exposure to the region.
There is an understandable predominance of Brazilian equities in the portfolios. The traded volume of the local equity markets is around US$1 billion per day, of which more than 2/3 is in Brazilian stocks; the market cap surpasses US$750 billion (US$350 billion is Brazil) and the total number of listed companies reach 1,400 stocks (360 in Brazil), of which 300 names probably with reasonable liquidity (that figure includes the ADRs in NYSE). Compared with Asia (where India alone has more than 6,000 listed equities), this is still a fleabite, but the number is growing rapidly.
There are three key drivers of this recent phenomenon: a) availability of shorts, b) higher quality and more experienced managers and c) increase of liquidity.
- Availability of shorts: it is possible to short stocks at a decent cost, sometimes as low as 2-3%. Besides, there is a reasonable menu of derivatives to play with, index futures, options, including derivatives on liquid ADRs;
- Higher quality managers: the migration of traders from prop desks and private pools of capital to the hedge fund industry has raised the bar in terms of experience and skill;
- Increase of liquidity: this is particularly beneficial for the mid and small cap names, which so far have only attracted the attention of small boutiques and specialised funds
In our opinion, the availability of shorts and higher quality managers consist in irreversible and structural drivers for this strategy. However, as we have seen in the past, liquidity can oscillate more than one portfolio manager might expect and therefore liquidity risk is something that any allocator looking at this industry should be extremely careful.
Finally, similarly to Asia, the opportunity in Latam is clearly the information arbitrage-getting to know who the good local players are still gives an edge to an allocator. We see more alpha generation and added value in the locally-based managers who have a better information flow than managers based in London or New York. One supporting argument for this thesis is that recent academic research has shown that there is little cointegration among Latin equity markets although there is some cointegration between Mexican and US equity markets2.
If it is true that correlation among Latin markets has decreased, then the access to information becomes even more critical and might explain the outperformance of local managers.
1 Eurekahedge lists 14; GFIA sources account for about the same again.
2 TABAK, Benjamin and LIMA, Eduardo-"Causality and cointegration in Stock Markets-the case of Latin America", Brazilian Central Bank working paper series, Dec 2002; PIESSE, Jenifer and HEARN, Bruce-"Transmission of Volatility across Latin American Equity Markets: Tests of Market Integration", research paper 015, King's College London, Nov 2002; GARRETT, Ian et al.-"The Interaction between Latin American Stock Markets and the US", Manchester Business School, Dec 2004.