HEDGE FUNDS HAVE not, in aggregate, done well in emerging markets. When times are good they can make money trading in and out of positions, but when times are bad they can blow up spectacularly – the prime example being the Russian default in 1998.
Today, however, times are good, and the hedge funds are back in the emerging-market asset class with a vengeance. Volumes are reaching levels not seen since 1997, and a whole new asset class – credit derivatives – has given market participants the ability to make the kind of trades they could only have dreamt of a few years ago.
A new breed of hedge fund is active in the market today: old-school funds like Soros and Tiger would make large directional bets but nowadays relative-value trades are more fashionable. All the same, says Steve Kenny, a trader at UBS in Stamford, "hedge funds and prop desks are driving the market on a day-to-day basis".
We've been here before: the last time the market looked like this the crises in Asia, Russia and Brazil devastated leveraged investors and panicked them into a rush to safety. This time they seem to be more prepared. So far, though, of course, they haven't really been tested.
Volumes have been rising steadily. Total trading volume in emerging-market debt was $2.19 trillion in 1999; that rose to $3.07 trillion in 2002 and $3.97 trillion in 2003. Trading volume in the first four months of 2004 was up 20% even on 2003 levels.
Leveraged volumes have been growing even faster still: proprietary trading desks and hedge funds made up just 15% of trading volume in 2002's sluggish markets but account for some 40% now.
Today's hedge funds are not the likes of Soros and Tiger, which dominated the market in emerging-market debt before they suffered enormous losses in Russia and left the asset class to the real-money, non-leveraged investors. Over the past couple of years, smaller, younger hedge funds, often less leveraged then their forebears, have moved into the market, attracted by the combination of low funding costs and a much wider range of instruments.
Relative value
"In the past, hedge funds took big long positions in external debt. Now, there's more relative-value trading between external debt and local markets, or equities," says Jonathan Bayliss, quantitative strategist at JPMorgan. Relative-value trades, of course, involve going in and out of various markets a lot more often than an old-fashioned directional bet – so it's not surprising that volumes have risen as more attention has been paid to new markets.
The catalyst for the explosion in new markets, says a trader in New York, was the behaviour of the dollar-denominated debt markets in the spring of 2002, as it slowly became obvious that Lula was likely to become the next president of Brazil. "Local markets blew up first," he recalls. "They gapped almost 1,000 basis points before it spilled over to external markets. People learnt their lesson from that."
The low volumes and illiquidity that plagued the Brady market at the time made it hard to make money by trading sovereigns' foreign debt alone. The local markets, if nothing else, provided an arbitrage opportunity for traders and hedge funds starved of ideas for the dollar bonds.
So the Brady desks in New York started paying attention to markets other than their own. Local fixed-income markets, especially in Mexico, became highly liquid, as did a lot of the foreign-exchange markets. Dealers were suddenly finding themselves talking to domestic pension funds in Latin America – a whole new class of client, which gave them a fresh perspective on the markets. And credit default swaps (CDSs) took off in a big way, allowing much more sophisticated hedging as well as the ability to put on very specific positions.
"We do a lot of currency and equity trades," says Rob Citrone, a veteran emerging-markets hedge fund manager who worked at Fidelity and Tiger before setting up his own shop, Discovery, five years ago. "It gives us a lot more information: one market will move and another will not. It also allows you to express your view more clearly."
One set of instruments that has become increasingly popular in recent months is index products. These are not really geared towards hedge funds specifically: if a crossover investor considers himself over- or under-exposed to emerging-market debt for whatever reason, he can simply go short or long the iBoxx, rather than, as in years past, crudely go short or long the Brazilian C bond as a proxy for emerging-market debt. Hedge funds, naturally, find all manner of arbitrage opportunities in such products.
Index products are also finding their way onto the radar of other funds that might not know the first thing about specific emerging markets but know that US growth, say, while it might hurt US bond prices, will probably help bond prices in developing countries generally.
They are exacerbating the general trend of the past couple of years, in which emerging-market bonds have traded as a group, with less and less differentiation between credits. Russia, Indonesia, Panama, Turkey, Ukraine, and Peru, for instance, all trade at a stripped spread between 310 basis points and 375bp over treasuries: a very tight range for countries with such huge differences in stability and creditworthiness.
The trader's nightmare
One consequence is that the kind of trades that economists might like to recommend – go overweight one such country and underweight another, for instance – become much more difficult to make money on. But the traders aren't feeling the squeeze yet: the cash bond market is highly competitive and transparent, but many local markets and credit default swaps are not, and are therefore very profitable. Transparency, after all, is every broker-dealer's worst nightmare.
Nevertheless, says Vineer Bhansali, head of analytics at leading real-money firm Pimco: "The market has got a lot more transparent. Hedge funds are being required to get active third-party pricing, and dealers are more transparent with their prices." Pimco now has real-time access to the trading screens of three different banks, although its very large trades are still usually done over the phone.