21/04/2010 Author: Tony Griffiths

Bric and beyond

After years of hype, it seems the potential of the world's emerging markets, lead by the Bric economies – Brazil, Russia, India and China – is finally being realised. With developed markets proving slower to recover from 2008's bodyblows, it is these newborn economic powerhouses, and the nascent frontier markets following in their wake, that are capturing investor attention

In the topsy-turvy world of 2010’s financial hierarchy, the tortoise has well and truly overtaken the hare. Emerging markets – so long the underdog in the economic race – have stolen a march on their Western cousins, who, still licking the wounds sustained in 2008, continue to limp and crawl their way out of recession.

Of course, the recent success of emerging market hedge funds has been very apparent. Returning 44.15% in the last 12 months, the HFRI Emerging Markets (Total) Index proved to be one of the brightest stars within 2009’s already lustrous galaxy, as the Bric countries, China in particular, led the world economy back towards surer ground. Commodity-rich Bric, and its frontier market counterparts, now offer investors some of the best opportunities for growth, and, more importantly, returns.

Even Western-focused long/short equity funds, such as London-based Sam Capital, are filling their portfolio with emerging market connections. “There is a growing expectation that the companies that will do well are the ones that have some sort of growth prospects through their business lines in the emerging markets,” Andrew Kennedy, the firm’s COO, said last month – echoing the sentiment of many equity-based funds HFMWeek approached.  

An increasing number of new offices in emerging market regions have also begun to spring up. Morgan Stanley’s Brazilian prime brokerage offering may have grabbed the headlines, but hedge fund giants GLG Partners and DE Shaw have also been the subject of recent speculation, both planning moves to China.   

And so, the clamour for hedged emerging market opportunities shows little sign of abating. Only now, investors as well as managers are responsible for driving demand. “People are gradually accepting that, from an economic perspective, the world has changed irreversibly over the last two years and it’s not too late to have a piece of the action,” says Julian Mayo, a director at emerging markets manager Charlemagne Capital. “What happened globally with the debt crisis has made investors open their eyes to the relative merits of emerging markets against developed markets.”

“We have certainly seen some significant increase in interest from our pension fund clients in emerging markets,” adds David Thompson of investment consultant Redington. “Looking at the expected future economic activity in emerging markets relative to developed markets over the next five to ten years, more clients are realising an increased allocation to a diversified emerging market portfolio makes sense. This has been the case in both equity and debt.”

For emerging market hedge funds as a group, recent months have been characterised by steady if unremarkable gains, and, as with general equity, there is a sense that 2009’s easy money is drying up. Mayo highlights the “cyclical nature” of emerging market opportunities – as the early-2009 boom in Asia made way for Brazil-focused excitement in the latter part of the year – suggesting that, going forward, a flexible, global approach will best capture emerging-world performance.  

According to Charles Robinson, global head of alternatives distribution at HSBC Global Asset Management, investors are accepting they can no longer rely purely on exposure to the traditional geographical heavyweights. “Particularly post-crisis, most investors prefer to find mangers to make country-specific decisions for them,” he says. “Having been damaged by China and India specifically, many prefer to have a global solution or a pan-regional product these days.” Helping to launch this month HSBC’s Ucits-compliant emerging markets hedge fund, Robinson has been in Asia seeking early-stage capital and finding many investors eager to be day-one participants.

Demand for emerging markets is growing among investors, but expectations have been tempered. The focus is increasingly global – though often implemented, like the HSBC fund, on a bottom-up, company-first basis – and one that only specialist managers can provide.

RUSSIA AND EASTERN EUROPE
11.73%
HFRX Russia/Eastern Europe Index YTD

43.23%
Last 12 months (as of mar 2010)

“This year, of all the big markets, Russia’s probably been the stand-out,” states Julian Mayo of Charlemagne Capital. Mayo’s affinity for cyclical analysis of emerging market opportunities has Russia on top at the moment, following Brazil, and before it China, in leading the EM charge. Certainly HFR data backs the country’s current prominence, with Russia-focused performance strongest among all the firm’s emerging market indices.

At HSBC’s recently launched emerging markets product, the Ucits-compliant GEM Equity Alpha Fund, Russia has grown into one of the three biggest positions. “Our investment process is very bottom up,” explains Omar Negyal, one of the fund’s two portfolio managers. “This adds up to country exposure, but it’s driven by stock view.” In terms of Russia, the fund’s positions are primarily within the energy sector, Negyal says.

Emerging markets specialist Argo Capital Partners also employs a bottom-up approach to position selection, but is focused primarily on credit. “Although we operate globally, it’s fair to say that our biggest exposure is in Eastern Europe, mainly Ukraine and Russia,” says Stephen Rothwell, the firm’s director.

LATIN AMERICA
1.73%
HFRX Latin America Index YTD

39.61%
Last 12 months (as of mar 2010)

Morgan Stanley’s plans to open a prime brokerage office in Sao Paulo embody the hedge fund sector’s wider interest in Latin America. As revealed by HFMWeek, Plural Capital, a Brazilian-based Banco Pactual spin-out, will debut three offshore hedge funds next month, while Geribá Investments, a New York-based $120m Brazilian private equity firm, is set to launch its maiden hedge fund to outside investors. “A lot of the commodity stocks have done well in recent months, and Brazil remains a commodity rich market that’s done well,” says Julian Mayo of Charlemagne Capital.

Brazil is by no means the only South American country attracting hedge fund investment though. Emerging markets credit specialist Argo Capital Partners has significant exposure to Argentina and Venezuela, Stephen Rothwell, the firm’s director, reveals. Gramercy Advisors, the US-based distressed emerging investment firm, is similarly enamoured with Argentina. “There is compelling performance upside prior to the completion of Argentina's restructuring, and there is significant performance potential post-restructuring,” says Robert Koenigsberger, the firm’s co-managing partner. Gramercy’s two Argentina-focused funds were among the best-performing in the entire hedge fund industry in 2009 – up around 300% and 400% respectively.

FRONTIER MARKETS: MENA AND AFRICA
7.76%
HFRX MENA Index YTD

28.31%
Last 12 months (as of mar 2010)

Last month’s ground-breaking change in the iron-ore pricing system – expected to see the price of both iron-ore and steel surge – has manufacturers across the globe on tenterhooks. In commodity-rich Mena, Iran, one of the world’s biggest steel producers and second only to China in terms of its year-on-year increase in 2009, is likely to benefit more than most. Rouzbeh Pirouz, chief executive at Tehran-based Turquoise Partners, predicts that Iran will allow hedging techniques in the next two years, but, in the meantime, steel-based profits and a “consumption boom” will provide long-only opportunities in Iranian equity.    

In sub-Saharan Africa, many are predicting big things in 2010 – the region having been largely ignored in 2009. Simone Lowe, assistant manager of Thames River’s Africa focused fund of hedge funds, points to Nigeria as a strong all-rounder, where an undervalued banking sector, as well as opportunities in oil, gas and telecoms, are expected to turn the country’s stock exchange into a global top-performer this year. Elsewhere, Negyal’s HSBC GEM fund has a “broad range” of positions in South Africa, with industrials a key focus.   

ASIA EX-JAPAN
-2.08%
HFRX Asia Ex-Japan Index YTD

18.22%
Last 12 months (as of mar 2010)

The only Emerging Market to post negative performance so far in 2010, Asia ex-Japan no longer attracts quite the same fervent furore that it did in early 2009. Not that it’s without its opportunities. Korean ship-builders are a “particular” focus at HSBC’s GEM fund, says portfolio manager Negyal (a sector backed by several interviewees), while, according to Charlemagne’s Mayo, China’s banking sector offers good value for the contrarian investor.    

“It’s a sector where people have been very bullish over the last six months, but they’ve gone from bullish, to neutral, to throwing in the towel,” says Mayo. “However, China has gone from having some of the most expensive banks in the emerging world to some of the cheapest, and, I would say, taking a longer-term view, Chinese banks offer some of the most attractive opportunities of all stocks in EM at the moment.”
 
Argo’s Rothwell is of similar mind. “It may be that certain credits, in Asia perhaps, may be overheating – looking a little overdone in terms of the spread compression – and it’s possible that we may look to put shorts on there.