Improving regulatory and economic environments are helping the Latin American hedge fund industry mature beyond the locally driven investment culture. Joel Kranc reports
As a so-called developing market, Latin America, and specifically Brazil, is truly emerging as significant player in the hedge fund and alternative investment landscape. Financial reforms that began as early as the 1980s - such as to Chile’s pension system and the more recent regulatory changes which allow greater offshore investment by Brazilian institutions and investors - are having a significant impact on the region, its business culture and its sophistication as an alternative investment market.
According to the Emerging Markets Private Equity Association (EMPEA), private equity investment in the region surged from $1.3bn (€0.97bn) in 2009 to $6.6bn in 2010. While Brazil’s investment figures for 2010 ($4.6bn) are significant in their own right, other parts of the region have certainly had their share of investment activity. Investment in Latin America, ex-Brazil, increased 525% year-over-year to $2bn. And reports quoting Hedge Fund Research (HFR) indicate that hedge fund assets devoted to the region rose 75%, to $21.4bn, in 2010.
Community, centres, culture
Centres for alternative investment and hedge fund investing are emerging across the region, while Brazil has the most developed market and business culture.
“Brazil had a very inflated financial sector given the macro economic history, including very high interest rates that were in place after a period of high inflation and several defaults,” says Guilherme Ribeiro do Valle, founding principal with Greenwich, Connecticut-based ABS Investment. “Since the 1970s there has been a boom in the importance of the banks in the economy, not in a productive way. After graduating from college, during the 1980s and 1990s, most of the top talent preferred to join the banks instead of the productive sectors.”
These events made the financial institutions in Brazil extremely profitable and attracted some of the country’s best talent.
Allan Hadid, CEO of BRZ Investimentos in Brazil agrees, and says people that had banking backgrounds created the first independent funds. “They were in the front desk of several banks or managing money somewhere - so these were the only independent asset managers [in the country].”
Once inflation stabilised in 1994, and the independent asset managers started to develop, notes Hadid, the front desk and the investment banks started to develop their own asset management firms.
There is, however, a second wave of asset managers in Brazil. “Guys that used to work in those banks and asset management firms are beginning to open their own shops,” says Hadid.
Other hedge fund and alternative investment centres in the region include Chile, which has a well-developed pension market and asset management culture, as does Buenos Aires in Argentina. Mexico, the second largest economy in the region, is surprisingly under represented in terms of hedge fund activity, according to Ribeiro do Valle.
Interestingly, the hedge fund and fund of fund market in Brazil has developed and, in many ways, operates like the mutual fund industry does in other parts of the world.Ribeiro do Valle notes that any retail investor can access hedge funds offering daily liquidity either directly or through local fund of funds, so the Brazilian regulator, the CVM, has taken the stance that they need to be fully regulated, just like mutual funds in other countries.
“It’s almost like the mutual funds in Brazil have more leeway to invest,” says Ribeiro do Valle. “So you can almost see hedge funds being regulated like mutual funds, but with more flexibility and the ability to go long or short.”
Alper Ince, managing director with Pacific Alternative Asset Management Company (PAAMCO) in Irvine, California, says the hedge fund market must be observed both through the lens of the onshore as well as the offshore investor. Because of the way the hedge fund market is regulated, he says regulators provide local investors a “lagged position level of transparency” that is appealing to the onshore high-net worth individual and family office community.
For the offshore investor, Ince says it is the fund of fund investors as well as US endowments and large institutions that have been interested in the Brazilian hedge fund community.
The credit crisis of 2008 was a shake-up for the local hedge fund community, adds Ince, and may have forced many people out of those investments. However, in the local market, hedge fund investments are still dominated by high-net-worth individuals, he adds.
There is a mixture of investors, agrees Roberto Botero, director of portfolio advisory for Sciens Capital in the UK. There is a large proportion coming from local investors, both institutional and private. “Historically private investors have been the main source of funding for absolute return managers and hedge funds in particular,” he says. Since the late 1990s, institutions have been allowed to invest in offshore vehicles.
In Brazil, adds Botero, high-net-worth individuals have been the main source for offshore vehicles and some long/short equity managers. Institutions have been the traditional source for the ‘multi-mercados’ (literally multi-market) which concentrate on fixed income.
Most agree that the key strategies first adopted by hedge fund managers in Brazil were macro-dominated, pursuing foreign currency exchange, interest rates, equity and inflation plays, and allowing the first wave of managers to adopt a muli-mercado philosophy.
Ribeiro do Valle adds that there are essentially two other strategies currently being used by Brazilian managers: a long-only or very long-biased approach, similar to the standard mutual fund strategy of North America; and long/short equity, usually domestically-focused, low-volatility market-neutral funds.
The macro shops, according to Ince, are changing slightly. “Equity strategies emerged as rates have been declining in Brazil over the long run,” he says. “There are more opportunities in the equity side to generate alpha by going long on fundamentally sound companies and shorting fundamentally deteriorating companies. So it’s a really a function of opportunities shifting a little bit more to equities.”
Still, Hadid says the evolution towards more international strategies remains relatively slow. “Brazilian investors are still much too Brazil-centric,” he says. “After the Lehman crisis and the credit crisis abroad we found the best place to invest was in Brazil. What you are seeing is that a lot of international investment is coming to Brazil. [The managers] are not seeing the benefit of diversification right now.”
Not another Madoff
As we have noted, the hedge fund industry in Brazil is much more highly regulated than that in the US, for example. With daily reporting of NAVs, portfolio transparency on public websites and an active regulatory body, it is difficult to be an unscrupulous operator in Brazil. “It’s difficult for Brazil to have a Madoff case where the SEC or other lending institutions [didn’t] know what he was doing or how much money he managed,” argues Hadid. “The industry is very much regulated and very stable.”
Besides the strict regulatory environment, roles are clearly defined as well. For example, administrators for hedge funds calculate the NAVs and register who redeems and who subscribes. Custodians are responsible for making sure assets are liquidated and settled on a daily basis, while the manager decides what to buy and sell for the fund. According to Hadid, this separation of roles - which is still not the universal standard in the US - keeps the industry on the straight and narrow without any undue influences or conflicts of interest.
Seed money for Latin American hedge funds comes from a mix of sources. Local investors and high-net-worth individuals and families are still a large portion of investors.
“Historically, private investors have been the main source of funding for the absolute return managers and hedge funds in particular,” says Botero. But that is changing somewhat and since the late 1990s, institutions have been allowed to invest more into offshore vehicles than they were in the past. He adds that in the past three to five years, asset growth has been given a large push as local private and institutional investors have been able to access funds both locally and abroad.
“Cities and treasuries are starting to allocate, pensions funds have recently been allowed to invest particularly in Colombia and Brazil,” says Botero. “We have seen that for some of these funds that have offshore and onshore vehicles, some of their onshore vehicles are being made available to their retail investors for the first time. That’s part of the industry that is starting to develop.”
But high interest rates have spoiled Brazilian investors and most of their savings are still in bank deposits, notes Ribeiro do Valle. “Investors don’t have many incentives to take on pure equity risk,” he says. “So there is a high preference to the low-tracking error. The supply of money to Brazilian funds is still dominated by domestic investors, either directly or via their participation in the local fund of funds.”
The future of the hedge fund industry in Brazil, and the region as a whole, will be quite interesting going into 2012 and beyond. New free trade agreements within the region, as well as with other Asian countries, are going beyond just the commodity trade. Botero says many of the counter-measures taken during the credit crisis are cyclical and are beginning to have a positive effect on markets, specifically as inflation is coming down.
As markets regain strength and investors adapt by becoming more sophisticated, and as offshore money flows into the region, the growth of the hedge fund industry is sure to play a significant role in the investment environment.