Author: Colin Lloyd
Linear Talk – 2016 Top Hedge Fund Strategy– Emerging Markets – September 2016
Emerging market hedge funds have been the top performing sub-strategy so far this year. In this article we will take a closer look at the sector and discuss the prospects for the rest of the year.
Below is a table showing the Barclayhedge – Emerging Market Index since 2012. The August 2016 data is based on 371 reporting funds:-
Barclyhedge describe the emerging market hedge fund strategy as investing in equity and fixed income markets around the world. They go on to point out that many emerging markets do not permit short selling, nor offer viable futures or other derivative products with which to hedge. In other words many of the managers employ a long-only approach.
The Barclayhedge index may give an unfairly negative picture of the 2015 emerging market performance. The broader based Eurekahedge Emerging Markets Hedge Fund Index reads as follows:-
August 2016 +1.03% 2016 YTD +6.71% 2015 +3.16%
Asset Flows and Sub-sector Performance
After challenging conditions since September 2014, emerging market hedge funds have seen in-flows since March. The Barclayhedge EM Index garnered $10bln between Q1 and Q2 but, as the Wall Street Journal reported last month, this was entirely eclipsed by the $67bln of new capital allocated to emerging markets in general between March and July alone. Major equity markets such as Russia (RTS +31%) and Brazil (Bovespa +36%) have benefited, but strong performance has been evident in some “near- frontier” markets such as Pakistan (Karachi +19%). This trend is not particularly broad-based in other frontier markets, the HFR EM MENA Index was down 6.7% YTD at the end of July.
HFR reports that Latin American hedge funds have had a particularly good year, reversing declines seen in four of the last five years. The HFRI EM: Latin America Index increased 8.9% in 2Q, and a further 4.3% in July. YTD the index is up 24.4%. This is the strongest 7-month performance since the 7-months ending October 2009.
HFRI EM: Russia/Eastern Europe Index also saw strong performance, rising 5.4% 2Q, bringing the YTD performance to +14.7% through to the end of July.
Aside from stock specific factors, the principal driver of performance has been the continued accommodative policies of the major central banks. The Federal Reserve has delayed tightening, whilst the PBoC, BoJ, ECB and BoE have increased stimulus. Within the fixed income markets, capital has flowed out of low yielding developed market bonds – even as they breached historic low yields – searching for returns from higher yielding emerging markets. This “quest for yield” effect is not new but emerging bond markets are generally quite small so a slight change in demand can have a dramatic effect. In many cases, prices have risen without any actual trading.
In equities, the relative over-valuation of many developed markets has encouraged investment in emerging countries, many of which have underperformed their developed market counterparts for several years.
Rotation into emerging market hedge funds has also flowed from the worst performing hedge fund sub-index, European Equity (-5.56% YTD). Italy’s FTSE MIB Index is down 23% YTD whilst Hungary’s Budapest Index is up 17% – to pick an Eastern European neighbour – may have been a direct beneficiary. The Budapest Index is now 50% higher than it was in September 2013. It may still represent a bargain, as the table below from Starcapital.de, which was calculated June 30th shows. Hungary ranks 6th cheapest of the 40 stock markets they:-
Looking ahead, turmoil in Turkey appears to be subsiding, although Moody’s downgraded their sovereign credit rating to junk status yesterday. Turkish stocks have rallied from their lows in July, as has the TRY, which suggests the attempted “military coup” was atypical. The table above highlights the attractive relative equity valuation of the Turkish equity market. However, geo-political risk, questions about the independence of the central bank and concerns about the government’s ability to finance its spending are not captured by these metrics.
Another way to assess value is to look at the longer term performance of these markets. The table below looks at a sub-set from the table above:-
Russia is still languishing relative to 2013 whilst China, despite the stock market collapse last year, is 44% above its level of summer 2013. Karachi, rather like Budapest, is already more than three years into its bull run. On the basis of three year performance, Turkey looks attractive, as do Thailand and Brazil. South Korea, though not technically an emerging market, also looks reasonably inexpensive and should benefit from a rise in its exports due to the strength of the JPY.
Any analysis of emerging markets would be incomplete without looking at the real yield on government bonds. The table below is arranged by highest real yield, but I have also included columns showing the change in yield and the value of the currency versus the US$ over the last 12 months – remember the Greek currency is still the Euro:-
|Country||Yield||Inflation||Real Yield||1yr yield change||1yr change vs USD|
|South Africa 10Y||8.565||5.9||2.665||0.02%||1.44%|
Source: Investing.com, Trading Economics
Pakistani bonds might be attractive relative to stocks on this basis but political risks remain. Mexican bonds also look interesting but it makes sense to wait until the US election result is known. The MXN has fallen in the last few weeks and the central bank is expected to raise interest rates if this weakness persists. For those investors brave enough to have bought Brazilian and Indonesian bonds it has been a great 12 months with yields falling and their currencies appreciating. If positions are unwound these trends could rapidly reverse.
As I mentioned earlier, many of these bond markets have limited liquidity making them difficult to enter or, more importantly, exit. They mostly offer a higher bond yield than dividend yield, at least partly due to the level of inflation. The final table ranks a sub-section of the emerging markets by dividend yield minus bond yield. These levels are from Friday 23rd:-
Source: Investing.com, Trading Economics, Starcapital.de
Turkish bonds – the yield has risen 30bp since Friday – may be worth considering in view of the differential between stocks and bonds. The TRY is little changed from a year ago and the political situation seems clearer. The Moody downgrade is now broadly in the price.
Emerging markets continue to offer exciting investment opportunities. Many emerging bond markets offer real-yields and some emerging stock markets even offer real dividend yields. Due to a lack of liquidity and currency risks, emerging markets will always be subject to rapid reversals. It
therefore makes sense to consider specialist hedge fund managers, who concentrate on delivering absolute rather than relative returns. Their skill is in managing risk, in a way that benchmark style investing cannot. 2016 has been a great year so far and I believe the sector will continue to benefit from the QE policies of the major central banks.
Download the PDF HERE