Hedge funds pick emerging markets for rates simplicity

Date: Wednesday, April 11, 2012
Author: Tommy Wilkes, Reuters

Hedge funds believe more predictable monetary policy in emerging markets is making it easier to profit from bond and currency bets there than in developed markets. Central banks in emerging markets face a classic trade-off between inflation and growth, the funds say, in contrast to policymakers in the U.S. and Europe struggling with rock-bottom rates and doubts about whether to restart printing presses.

Managers are confident enough about the priorities of central banks in countries like India, China and Brazil to place bets on the direction of rates.

"It's far easier to forecast what a central bank in the emerging markets space is going to do than try to forecast what the Fed's going to do or the ECB's going to do," one hedge fund manager, who spoke on the condition of anonymity, said.

"Most of the emerging market curves are not as well traded, there are many more discernable reaction functions to the central banks."

The average emerging market hedge fund has gained 8.69 percent this year to the end of March, beating the average hedge fund's 4.91 percent rise, according to Hedge Fund Research.

Strong equity returns drove much of this, but macro funds, which look to profit from economic trends and shifts in monetary policy by betting across asset classes, have also done well.

Pharo Management, the $3 billion firm run by Guillaume Fonkenell, has seen its flagship emerging markets macro fund rise around 3 percent by mid-March, one investor said.

BlueCrest's Emerging Markets Fund had risen 2.85 percent by the end of February while Brevan Howard's Emerging Markets Strategies Fund, run by Geraldine Sundstrom, was up more than 10 percent by early March, performance data seen by Reuters shows.

NO LONGER THE SAME

Emerging market funds are still a relatively small part of the hedge fund industry. HFR estimates that of the $2 trillion in assets held globally, just $118 billion lay with dedicated emerging market hedge fund managers at the end of last year.

Macro funds hold less than 12 percent of this, but many global managers - their strategies struggling with low rates and a lack of strong policy trends to trade in the developed economies - now have a mandate to move into emerging markets.

"We had this big flight to safety to the U.S. and to Germany within the euro zone, and I think that is beginning to unwind," Paul McNamara, a portfolio manager at GAM, said.

To express this view, McNamara said his rates fund, which is up 4.19 percent in 2012 according to Lipper data, is positioning for the spread between emerging market local currency bonds and U.S. Treasuries closing.

Others have also been betting on emerging market central banks cutting rates to try and kick-start slowing growth even as inflation, long a worry for many, remains at elevated levels.

This trade usually involves buying 2-year bonds or entering into a rates swap and has already made managers money after yield curves steepened to anticipate looser monetary policy.

Brazil, for example, cut borrowing costs to their lowest level in almost two years in March, while China has reduced banks' reserve ratio on several occasions.

"What it really tells you is that a lot of emerging market central banks perceive the cost of a slowdown to be much higher than the cost of elevated inflation, at least in the short run," Kay Haigh, ex-head of Emerging Market Trading at Deutsche Bank and now running Avantium Investment Management, said.

Bets on currencies are also popular, based in part on the notion policymakers will not inhibit a gradual rise in units some see as fundamentally undervalued versus the U.S. dollar.

"Latin American currencies have appreciated significantly but it has been easier to make gains going long...the Singapore Dollar and Malaysian Ringgit. Early this year the South African Rand was also profitable," Roberto Botero at Sciens Capital Management, which invests in hedge funds, said.

Despite the gains to be made, managers stress the need to examine each central bank's thinking independently.

India, for example, kept rates on hold last month despite its slowing economy, and raised the spectre of rising inflation in Asia's third-largest economy.

"Typically, one ought to shy away from tipping all these emerging markets into one basket. A few years ago people would say if one of them cuts, all of them cut, or if the Fed cuts all of them cut, but that picture has changed," Haigh said.