We don't think risk is being appropriately rewarded at the moment. Whether it's tight emerging market bond spreads or cheap equity market volatility, our managers continually tell us the world's gone wrong.
Well, maybe now risk is being a bit more appropriately rewarded. There's little point in reprinting the column-miles we've already read in the financial press about flight to quality, concerns about sub-prime lending in the US, the unwinding of the carry trade, etc. But it's a good time to reiterate why we focus on hedged managers, in emerging markets.
First, why do we focus on developing capital markets? Well, as my 12-going-on-16 year-old daughter would say, "Duh!". Why do you rob a bank? Because that is where the money is. Developing markets are less efficient, meaning greater opportunities for good investment professionals.
Why hedged managers, when the underlying economic growth of the developing world is so high that buy and-hold would seem to be a no-brainer? Because the inefficiency of the associated capital markets and the (general) lack of stabilising domestic institutions, makes emerging markets too volatile for many investors. The graph shows how emerging markets have outpaced developed markets, but also highlights how vicious the downdraughts can be. Without any clever maths, while over the past two years you'd have made 70% in US dollars just holding emerging market equities, you'd also have had three or four periods when you'd have seen a peak-to-trough drawdown in excess of 10%, and one of 25-30%. Perhaps thankfully, the graph doesn't cover the last few weeks!
The takeaway is that, if you have the stomach and the time horizon to make 30% losses from time to time, and to ignore them (and your investment committee, trustees, CIO, head of marketing, or father-in-law - whoever you report to) has the same level of market insouciance, you should save yourself the fee load and just invest in a well-run global emerging market equity mutual fund.
Realistically, most investors would far prefer to avoid such occasional losses, and would trade some upside for a safety net. The most obvious argument for using hedged or absolute return managers in these markets is to avoid some of the downdraughts.
Our funds of funds, and those of our clients that focus on these markets, may have fallen in value because of the recent market falls. But they will have fallen by far less than a plain vanilla long-only mutual fund, because the underlying managers generally, one, hedge out some, or often a lot of, market (or any other) risk, and, two, can vary how much of that market risk they want to take at any given point, depending on their evaluation of the risk/reward trade-off.
Point one means that in any case, correlations with markets are less than one (for example, our GFIA 2006 Asian fund of funds has a historic correlation of 0.2 with both the MSCI global EM index and the Nikkei 225).
Within our Asian portfolio we have, for example:
n a relative value regional equity manager, with no market correlation and a structural exposure long of volatility to benefit from market spikes;
n a relative value commodities manager, with again no equity market correlations, and well hedged commodity exposure (which is as often negative as positive); and
n a relative value China manager, that although he takes significant risk, does not use directional market exposure.
Point two means that the skill we're paying 1.5% or 2%, and 20%, for, will often calculate, sense, guess, or evaluate the likelihood of market falls, and take off risk as a discretionary decision.
We had a conference call in the second week of March with the India long/short manager in our portfolio. Going into the last week of February, they had only about 25% exposure to the market. They'll still have lost money, but far less than our friends the mutual fund managers. As a manager noted in a monthly that's just crossed my desk, in a gloriously pointed slice of schadenfreude, "… in the space of a single day, the equity markets vapourised more wealth (approximately $1.5trn), than is managed by the entire evil hedge fund empire". If you were a long-only investor, that vapourised wealth was all yours.
The principal of one of the larger Asian equity long/short funds that we know well says he
understands clearly that his job is to deliver two-thirds of the upside of Asian equity markets, and one third of the downside. Delivering on that implicit mandate has taken his fund from a standing start to over $1bn within three years.
ut the more sophisticated argument is that, not only do good hedged managers avoid some of your drawdown risk, they can also source returns in areas off-limits to, or very difficult for, conventional managers. In the last issue we discussed value realisation in Japanese small caps; this relatively illiquid and expensive to research opportunity set is probably too difficult for most mainstream Japanese equity funds.
Arbitraging volatility in Korean options, liquid but hugely mispriced by their predominantly retail investor base, is not feasible for a mutual fund. Disintermediating Brazilian banks by offering factoring or agricultural finance; asset-stripping a Singapore-listed company; providing bridging finance to mid-sized Japanese manufacturers; arbitraging commodities for Osaka delivery against those for Singapore delivery; financing a Chilean management buy-out… Hedge funds offer a route not only for risk management in developing markets, but also to participate in return drivers that just aren't available easily elsewhere.
Peter Douglas is the principal director of independent fund research house GFIA in Singapore. He is also the Singapore chapter head for AIMA