The Latin American continent is host to a population of around 500 million people living in twenty-one countries from the US-Mexican border to the Terra del Fuego and is spread over 20 million square kilometres. On a PPP-adjusted GDP basis, Latin America represents around 7.6 per cent of the world’s total. Its capital markets are well developed as it represents close to $3,000bn (€2,342.5bn) in domestic and offshore debt instruments, which trade an estimated $11bn a day, according to an EMTA survey. The equity capital markets have experienced considerable growth in the past few years and now represent about $1,200bn, or 20 per cent of the MSCI-Emerging Markets indices.

A developing, albeit still small, hedge fund market

According to various providers, the Latin American hedge fund market hovers around $25bn in assets, spread among approximately 250 hedge funds managed by in excess of 100 different investment groups. While small, as it only represents about 2 per cent of global hedge funds in total, the Latin American hedge fund industry is vivid and growing at a rapid pace. Although the number of new hedge funds launched was less than 20 a year at the end of the 1990s, it reached 35 in 2003, 40 in 2004 and was in excess of 50 in 2005. A few hedge fund groups are rapidly approaching the $1bn mark, while Rio de Janeiro-based Gavea has recently crossed the $2bn mark and São Paolo-based Hedging Griffo runs in excess of $3bn in hedge fund assets.

Brazil takes the lead and hosts the two local hedge fund centres

Data collected by Claritas (a research paper by Shinohara and Batista, April 2006) sheds an interesting light on the structure of the Latin American dedicated hedge fund market. Around 90 per cent of the hedge funds are dealing in Brazilian securities, representing a similar breakdown for the geographical focus of the funds as well as the location of their managers. Sao Paolo may have the lead in terms of number of investment groups having elected it as a base, but it seems on par with Rio de Janeiro, when compared by assets managed. Rio claims to have an edge in terms of quality of life for its managers and attraction capability for international investors to come and visit them. There are a few managers based in other Latin American countries, such as Argentina’s Copernico or Cima Aconcagua, but most of the other specialists are located in New York, London, San Francisco and a few in Miami.

From a home-grown, affluent client base to an international, sophisticated one

In Brazil, the number of onshore funds is still far greater than the offshore, internationally dedicated versions. A ratio of close to 5:1 is indicative of the degree of development of the local hedge fund capabilities but also of the fact that they are still to be discovered by international investors.
This will happen sooner rather than later as there are strong reasons why the local
fund managers are keen to diversify their client base.

To attract capital in the context of very high, short-term nominal interest rates (around 15-20 per cent a year in the past few years), local fund managers have had to offer daily liquidity with a few days redemption notice and present their performance as a percentage of the CDI (domestic T-Bills). This did not prevent the often extreme short-termism of local investors to take its toll. Counselled by their professional advisers and local private banks, Brazilian clients have indeed proven to be remorseless and intolerant of any weakness in performance. Therefore, successful and well-staffed groups have seen their assets take a huge plunge when going through a soft patch. It has not been lost on domestic fund managers that an international, sophisticated client base is less short-term orientated and more absolute return minded, making it more suitable and enviable.

Origin and evolution of the local hedge fund industry

While the global hedge fund industry traces back to 1949 and New York-based Alfred W. Jones, the Latin American “chapter” is a recent occurrence. Indeed, before experiencing the past few years of strong growth, the Latin American hedge fund industry had to wait for the region to achieve relative stability, be it on the political, currency or economic front.

In the context of hyperinflation, those who had any assets left were rather looking to send them abroad to be invested in hard currencies or were concentrating on domestic hard assets. Raising money for funds, hedge or otherwise, was simply too challenging. With the introduction of the Real Plan in 1994, the first hedge funds appeared in Brazil, but soon the other emerging markets fell prey to crisis, with Mexico in 1994, Asia in 1997 and Russia in 1998. Overcoming Brazil’s own crisis and devaluation in 1999, the industry started to develop again and new players emerged. The Ecuadorian and Argentinean defaults did not impact the markets as much and the industry managed to gain strength despite these two

additional setbacks for the region. Finally, the extreme volatility induced by Lula’s election in Brazil and followed by a surprisingly orthodox economic policy provided for a favorable environment for hedge funds start-ups.

Growing in breadth and depth, wider diversification in terms of strategies

Initially, the vast majority of hedge funds were fixed-income focused with a component of currency management. They responded, and still do, to the denomination of “multimercado” or multi-strategy funds. Equities as an asset class were rarely used on a stand-alone basis and, when at all in the context of multi-strategy funds, only opportunistically and in minor proportion. This has now changed as many multi-strategy funds, especially in their offshore version, achieve the majority of their returns from, and allocate an important part of their risk to, equity-related strategies. Nowadays, long/short equity fund managers represent in excess of a quarter of all Latin-American fund managers and manage around 20 per cent of the total assets. Successes, such as Rio-based Polo Capital, are providing a true regional, event-driven fund with diversification in other equity related strategies.

The other half of assets is managed in macro-based strategies. These funds follow a top-down, trading-oriented approach with a marked bias towards Brazil, reflecting the proprietary trading background at local investment banks of their managers. They also deal in other emerging markets and, to a lesser degree, in G7 countries as well. While distressed debt securities, relative value and fixed-income arbitrage strategies are represented in the Latin American space, there may be additional growth for asset-backed securities funds. In Brazil especially, the lack of private sector financing offers opportunities in the cattle, ethanol, forestry and consumer loan segments.

State of the art regulatory framework with room for improvement on corporate governance

The Brazilian Securities and Exchange Commission (CVM) is highly regarded and often considered to be on par with its US and European counterparts. It oversees the whole industry and has been enforcing registration for any investment management company (including hedge fund management groups) based in Brazil for many years. While the supervision of the fund managers is tight and rigorous, there are a few significant issues regarding corporate governance of the listed companies. These often revolve around the rights of the minority shareholders, which, on occasion, are bluntly disregarded. With the appearance of the Novo Mercado in Brazil, where dual share listings are not allowed, a trend towards improved corporate governance has been set in motion. Also, many companies have recently granted tag-along rights to the holders of preferred (non-voting) shares, enabling them to be offered 80 per cent of the ordinary (voting) share price in the case of a takeover.

The first element of attractiveness is related to the quality of the managers

At the current point in time, we view the Latin American hedge fund market to be a source of great opportunity for global investors due to three main factors. First and foremost, there is an impressive quality of people to be found. Well educated, hard working, experienced, ingenuous and risk aware hedge fund managers are driving the growth of the industry. A local presence is of great help in both identifying and monitoring these managers. Also, the expertise and global perspective of a time-tested hedge fund selection team is required as, unsurprisingly, not all local fund managers are world class yet and a few are even fraught with serious operational risks.

The macro environment is most favourable for Brazil’s continued success

Second, after many wandering decades, Brazil has finally got its act together. Inflation is under control and should be around 4 per cent in 2006. The balance of payments has swung from a large deficit only a few years ago to a comfortable surplus. Hard currency reserves at the central bank more than balance Brazil’s still outstanding external debt ($70bn vs. $50bn). The Real has regained its level of the pre-Lula election panic and rallied from R$4 to R$2.15 against one US dollar. Real interest rates of around 10 per cent offer plenty of room for the central bank to loosen its monetary policy, which should reflect positively on economic activity and the equity market as well. In a nutshell, Brazil never had it so good!

No crowded place and ample room for hedge funds to grow

Finally, Latin America is host to only one fiftieth of the global hedge fund industry. It is not crowded, which is more often the case in other continents and in a number of strategies. Also, liquidity has grown considerably in the region and, although it is never there when one needs it most, it is likely to improve further as the capital markets keep on developing and pension funds continue growing. Inefficiencies coupled with volatility are of prime interest to funds of hedge fund providers. However, very few have launched dedicated products.

There are still several risks involved

Stefan Zweig once famously said that “Brazil is the country of the future and always will be”. Many sceptics credit China and global, synchronised growth for Brazil’s recent progress. They warn that structural inefficiencies have not been addressed and that they leave the country vulnerable to a global slow-down. If China or the US consumer sneezes, Brazil will catch the proverbial cold, they warn.

Another source of risk rests with the political shift observed in the region with the subsequent elections of Venezuela’s Chavez, Bolivia’s Morales and Argentina’s Kirchner. All three run populist programmes and have taken anti-capitalist steps in their home countries. These have had occasional impact on their larger neighbour, as was the case in Bolivia’s nationalisation of Petrobras’ local operation. While Lula has been credited with conducting a reasonable economic programme during his four-year term, he is being challenged on his left by a former PLP minister, “Helena Heloisa”, who was expelled for her extreme leftist and volatile stances. Alckmin, the conservative challenger, is considered a much better choice but is widely reported to lack the charisma required to win coming elections in October. Despite Lula’s large advance in the opinion polls, uncertainty is rampant. A bad surprise cannot be ruled out, as “Helena Heloisa”, who only recently joined the race, has been credited with around 12 per cent of the voting intentions and seems to be making headway not only with Lula’s but also with Alckmin’s voter base.

Latin America has a role to play in a global portfolio of hedge funds

Opportunities in Latin America are coming of age and take the plural form this time around. What used to be a pure macro bet is evolving towards a more diversified play. Equity long/short, event-driven, asset-backed securities are growing strongly and are ready to complement the local multi-strategy and macro funds. As Brazilian interest rates continue to come down, a larger allocation to equity related strategies should prove even more rewarding. While Brazil takes the lion’s share of the current opportunity set, additional countries will further develop and soon be included in the hedge fund terra cognita. As often, early participants will be offered greater compensation for their pioneering spirit. Latin American funds have a role to play in a global portfolio of hedge funds.

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