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Malaysia to Morocco: the new world of alpha

The term "emerging markets" is synonymous with heightened emotions of greed and fear for global investors. Add the flexibility and advanced investment tools available to hedge funds in this arena and things get even spicier – or do they?

While some aggressive, directional funds can produce extreme returns both on the upside and downside, there also exist many hedge funds that seek to eliminate the tail-risk of emerging market investing by utilising efficient risk management and hedging techniques. Emerging market investing does not necessarily have to equate to 'emerging market beta'.

While stories of growth and reform in emerging markets have often led to periods of exceptional returns for particular countries, recurring economic crises, toppling of governments, and even natural disasters have often left emerging market investors with little reward in relation to the risks they are taking. Certain hedge fund strategies are however, very heterogeneous and when you look beyond the broad strategy classification you see a diverse set of investment styles and personalities. As with all hedge fund strategies, it is important to stress that a clear understanding of a specific hedge fund's characteristics is critical when talking about emerging market hedge funds. Some hedge funds focussing on emerging markets are indeed highly volatile, while others have long track records delivering stable risk-adjusted returns combined with institutional infrastructure. With the ongoing development of financial markets in many countries, it is clear that investing with alternative strategies in emerging markets should become a more important part of investment portfolios. 

New global approach

The attraction and potential opportunities from investing in emerging markets are well known: improving regulation and reform, GDP growth, positive demographics, growing export and import industries, can all lead to large gains in a country's equity, credit, and currency markets. Investors cite greater potential 'alpha' being available due to emerging markets operating less efficiently relative to developed markets, and that there are fewer sophisticated market participants competing to harvest that alpha.

As financial markets develop in various countries, hedge funds can use techniques previously only available in developed markets to take specific exposure to a company or macro factor, and hedge out any unwanted risk.

For example the ability to short shares is becoming more readily available across EM countries, although in some instances the cost of stock borrow can be very high. Funds can also take different views on the asset classes, for example buying local high-yielding bonds while hedging out the desired amount of currency risk. Even compared to 5 or 10 years ago, managers have a huge number of options available to them to construct portfolios. A recent example is the ongoing liberalisation of Chinese FX and bond markets, where several macro funds benefitted from the recent devaluation and spike in FX volatility.

Specific industry exposure can also be targeted, such as mining companies in South Africa, technology firms in Taiwan, or the coffee industry in Brazil. Furthermore, many participants will also talk of emerging markets being 'under-followed', creating more opportunity to generate alpha. For example a company such as Microsoft may have thousands of analysts around the world tracking each piece of information, while a cement maker in Hungary may have only a few interested followers.

The financial markets of the emerging world are constantly evolving, with each country at a different pace and with its own motivations. By developing efficient stock exchanges and a sovereign bond market, countries can attract capital and fund future growth. Liquid bond, equity, and derivatives markets all improve a country's economic reputation, plus also allow investment firms to express their views.

As countries continue to reform and evolve, an investor can no longer sit and dismiss emerging markets as too risky – the 'smart money' will be those who are already there to take advantage of exciting new opportunities. Many hedge funds based in London or New York have long-established local research offices across Asia and South America, markets where local contacts and knowledge is critical.

Hedge funds and emerging markets: a chequered history

While emerging markets offer tremendous opportunity and will continue to do so, past crises have also led to large losses, and the hedge fund industry has not escaped unscathed. In the modern era the most devastating shock came in 1998, where Russia defaulted on its debt, leading to large currency moves and ultimately losses for many hedge funds who had previously been buying GKOs, i.e. Russian debt. For many hedge fund veterans, this period still remains a sharp memory. It led to many hedge funds closing down, and was related to the infamous collapse of LTCM, the hedge fund that nearly caused a financial meltdown.

Compared with 1998, hedge funds sailed through the preceding Asian crisis of 1997 relatively well. In fact, some large macro funds foresaw the structural problem of the Asia "Tigers", and made gains primarily from their weakening currencies over the period. Mahathir bin Mohamed, Malaysian Prime Minister at the time, infamously blamed prominent macro manager George Soros for causing the financial crises. The two reconciled in 2006, but hedge fund managers remain politicians' favourite scapegoats to blame for ongoing regional crises.

On the flipside, there have been extraordinary periods of stellar growth for various regions, which have led to large profits for investors. Going back to the fall of the Berlin Wall, several funds were able to invest in fast growing eastern European states, as well as Russia as it opened up its oil industry. The rise of Brazil as a South American power led to large gains for many years via its currency and equity markets. Technology and manufacturing in Asia – from China to the Philippines – have also been rich areas of opportunity. Today, so called 'frontier' markets of Africa and the Middle East are gaining the interest of hedge funds as the emerging markets of tomorrow.

Different strategies

Hedge funds active in emerging markets typically fall into two camps: those who are 'investors' and those who are 'speculators'. Regional long/short (e.g. India-focussed) or global with a focus on emerging market equity managers fall into the first camp, while global macro funds could be described as the speculators. That said, often detailed macroeconomic fundamental research drives macro themes in hedge funds, as was the case for Soros in 1997. Today global macro funds are active in a very wide range of countries, from Brazil inflation linked bonds to African mining equities. The 'go-anywhere' approach of hedge funds allow them to invest in opportunities far outside the scope of traditional funds.

Macro funds can take outright directional exposure; or to reduce volatility, a relative value approach can be applied, for example Hungary versus Slovakia. They can also use more liquid developed markets as a hedge, such as S&P futures. The relative size of each size of trade would be constructed in line with the specific risk desired (i.e. VaR). Relative-value strategies, while potentially reducing risk, can increase complexity and create what hedge fund manager call "basis risk". The combination of basis risk and leverage has often led to trouble during bouts of illiquidity for certain hedge funds.

The largest category in emerging market hedge funds are those who specialise in equity strategies. Again, there is a wide variety of styles within this group; some managers can take a global approach and invest via equities with a top down thematic approach, while others can focus on one country and manage market neutral portfolios, trying to minimize beta. The global funds are typically managed from hedge fund hubs such as New York and London, while regional funds are typically managed 'on the ground', by a local who has built out a career at a local bank or fund management group.

The emerging market macro fund will take directional positions primarily in a country's bond and currency market, using traditional macro research sometimes with the help of on-the-ground economists) and behavioural finance techniques to predict market behaviour. Positions can also be taken in a country's stock market, although macro funds are more likely to use index futures and ETFs rather than single stocks, unlike the long short equity manager. The growing influence of certain countries can now affect other markets, for example the slowdown in China affecting the value of the Australia dollar, as we have seen in 2015 due to decreasing commodity demand. Similarly, the domestic growth situation on Brazil and Mexico has a large impact on smaller neighbouring countries within South America.

Conclusion

The world of emerging market investing remains the most likely to heighten the romantic senses of the modern investor. The love affair with emerging markets over time has conjured various terms such as the 'BRICs' (Brazil, Russia, India, China), and the 'Next 11' (Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, the Philippines, Turkey and Vietnam), both terms relating to a phase of exceptional growth for its constituents.

More recently the shine has come off emerging markets and the potential returns they may offer, most notably with a slowing China, conflict in the Middle East, and the vulnerable economies of the so-called "Fragile 5" (Brazil, Indonesia, South Africa, India, and Turkey). While a lack of strong growth and structural debt problems may affect some counties, as long as there are dispersions and change in the world the emerging market hedge fund manager will continue to seek out unique opportunities for investors. With the wide range of hedging tools and relative value techniques hedge funds can employ, they have a real advantage in the coming years which should enable good managers to generate profits as these countries develop.

As with every hedge fund strategy, it is critical to understand the underlying characteristics for each hedge fund as they vary widely under each strategy, and this is no less the case for those involved with emerging markets.

A version of this article originally appeared in the October 15 issue of Citywire's Modern Investor Magazine.

Citywire publishes independent news, analysis and fund manager performance information for professional advisers and investors in the global asset management industry. Modern Investor Magazine is a Citywire publication that gives institutional decision-makers insight into global investment ideas and asset classes, innovative investment strategies, themes, and investment managers.