Emerging markets have enjoyed great popularity among investors and over the last two years in particular, money has flown mostly into those funds which have historically proven to generate strong performance.
But there are growing concerns that the Arabic world’s political chaos may spread to other emerging markets. Combined with fears of inflation in a low interest rate environment, these have driven some significant recent outflows from developing countries. Capacity issues in equity funds are also leading fund selectors to look for alternative solutions across all asset classes to invest in the emerging market story.
“There has been a fundamental shift in client preference for emerging markets and today there are a few funds that are soft or hard closed, probably because the majority of inflows, especially in the equity space, have concentrated on a small number of large and well known funds,” confirms Pascal Botteron, global head of the fund research group at Deutsche Bank. However, the growing number of local managers and boutiques, which tend to outperform the larger funds, can absorb future inflows, he says.
For a big bank like Deutsche, investing in smaller funds is often not a viable alternative, as that would mean owning the fund, which would impact liquidity and performance. The solution that the German bank is currently examining is a fund of emerging market funds, which is expected to be launched at the beginning of April. This product will also have a capacity cap, says Mr Botteron.
He expects a number of regional or specific themes to catch investors’ interest. “To enhance our product offering and meet client demand, we have identified managers that play themes, such as domestic consumption or the urbanisation of emerging markets, which generates high demand for infrastructure, or those linked to the commodity story, where we offer investment solutions in the mining space,” says Mr Botterton, adding that single country funds such as Brazil, China or India are also popular.
While local companies are preferred to gain generally better access to local knowledge, the large established firms, which have long history, infrastructure and expertise, and can also have local presence, are recommended to gain exposure to the more global emerging markets theme.
The issue from a due diligence perspective is that, in emerging markets, hedge fund firms do not have the same standards of infrastructure as their counterparts in London or New York, says Mr Botteron. Risk systems and governance aspects can be insufficient, and small hedge funds often consist of just two or three traders and a Bloomberg terminal.
“We are conservative in our selection process and see increasing demand for absolute return funds that are both liquid and secure,” says Mr Botteron. “We are offering solutions in the Ucits III and managed account spaces, clients are receptive to both vehicles and have shown a lot of interest in our emerging markets funds in particular.”
Both long-only and absolute return products have their role in investors’ portfolios. With a long-only exposure in emerging markets, on the equity or bond side, an investor can really capture the emerging market growth story, he says. Emerging markets hedge funds are good instruments for their ability to short stocks. “Emerging markets can be viewed as less efficient than their developed counterparts, as a result there may be more opportunities to generate alpha. Many companies and sectors within emerging markets do not have a large volume of analyst coverage, as a result managers based in the region, or those with strong local knowledge have an advantage.”
The third reason to invest is related to local market expertise. “It is no secret that a lot of talent tends to end up in hedge funds because compensation and remuneration is sometimes more attractive than in mutual funds,” says Mr Botteron.
Emerging markets, traditionally hit by many shocks and catastrophes, are notorious for their high volatility, so the ability to go short can generate great outperformance, compared to an active approach or, worse still, a passive approach, according to hedge fund managers at GLG Partners.
“In emerging markets, the tails are fatter and the skew towards the downside is bigger and if a manager goes short into just one of these crises, capturing half of the returns of the collapse down, that will generate massive outperformance,” says Karim Abdel-Motaal, co-fund manager at GLG Partners. “Our job is easier than that of our peers in the developed world. Nothing will remove the need [for a manager selector] to find the right manager, but it does remove it somewhat more than it does in any other asset class.”
Hedge funds can better smooth volatility in a particular period which has encompassed huge market draw downs, but in a liquidity driven boom market, active funds probably do better than hedge funds in the main, believes Rupert Robinson, CEO of Schroders Private Bank in the UK.
