Emerging markets are receiving increasing hedge fund investments sparking calls for investment managers to get back to basics. With potentially more hot money entering the asset class, industry insiders would like to see the fund management industry become more selective and focus more on emerging markets' fundamentals.
In a year when some of the best fund returns have been made using short-selling strategies relying on market falls to return profits, Mohamed El-Erian, managing director at Pimco, who manages the largest portfolio of emerging market debt, argues that as emerging markets mature, investors should return to the fundamentals of picking good credits and sticking with them.
This view should sit well with government officials and regulators concerned over the effect heavy trading strategies have on more delicate emerging markets. Some hedge funds use synthetic financial structures to short sell in markets where short selling is not permitted.
So far, this has not been a great year for hedge funds generally, but investors dedicated to emerging markets have outperformed almost all other strategies, including arbitrage, global macro and event driven. Hedge funds committed to emerging markets have posted returns of around 5% above the hedge fund industry average, year-to-date, according to CSFB/ Tremont, a consultancy that monitors the industry.
Emerging markets proved the best strategy for hedge funds in August (the last month for which figures are available) with a return of 2.07%, according to the CSFB/Tremont Investable Hedge Fund Index. The index monitors 60 funds across 10 different strategies representing $92 billion of investments.
Positive figures like these are a good indication that emerging markets will continue to attract increasing attention from hedge fund investors. Stephen Jupp who works on the CSFB/Tremont Hedge Fund Index, says: "[Investment] flow comes in on the back of performance, so we expect to see money coming into the asset class."
Over the past year, hedge funds specializing in emerging markets have grown from 3% to 3.5% of the total hedge fund industry, representing an inflow of $6.2 billion into emerging market funds.
Emerging markets have benefited from the low global interest rate environment (despite this year's US rate hikes). "Emerging markets have been the best performing asset class over a three- to five-year period and we still have a good environment for emerging market returns," says Adam Weiner of mutual fund group Oppenheimer Funds in New York, which manages more than $155 billion in assets.
Emerging markets are likely to benefit from increased capital flows, but even within the industry some are concerned that aggressive trading strategies may damage markets. "Emerging market hedge funds do not simply rely on long-only investment strategies - they are using synthetic structures to short the market in markets that don't allow short investment," says an industry insider with knowledge of hedge fund trading strategies. Investment managers argue that financial instruments that allow investors to short a credit can have a stabilizing effect on markets by offering protection to investors that would not otherwise invest.
Regulators are looking more closely at hedge fund activities, particularly as they attract more mainstream investors. Regulators are worried by their lack of insight into the largely unregulated $600 billion hedge-fund industry. A recent report by the Securities and Exchange Commission (SEC) recommends hedge funds advisors register with federal authorities. The most recent SEC report stops short of calling for the actual registration of hedge funds themselves. There are about 6,000 to 7,000 hedge funds in the US, but only about one-third of hedge-fund advisers are registered with the SEC.
According to Hennessee Group's 2004 Foundation and Endowment Survey of 46 foundations and endowments that invested in hedge funds, 59% were in favour of the proposal requiring hedge funds to register with the SEC under the Investment Advisors Act of 1940. As a rule of thumb however, more experienced investors in hedge funds are against regulation and the 31% of institutions surveyed by Hennessee who did not support such a move manage three times as much capital and allocate 46% more to hedge funds.
Many larger hedge funds are resisting greater oversight by the SEC.