Brevan Howard Emerging Markets Strategies Master Fund Limited (BHEMS) is an emerging market multi-asset macro fund that has the freedom to express Geraldine Sundstrom’s top-down, fundamental views without any benchmark or tracking error constraints.The strategy manager and a team of seven strategists and analysts believe that correctly identifying where economies are in their business cycles, in terms of growth, inflation and credit, makes the asset allocation decision much easier.
For the last two years, BHEMS accurately judged that the global growth environment was weak, with no inflationary pressures and multiple liquidity injections from central banks. Therefore the logical asset class to own was fixed income and most of the fund’s 2012 profits came from receiving rates in emerging markets sovereign debt. Brazil stood out as a core and high-conviction holding, with bonds purchased at 15% yield and held all the way down to around the current 7% yield. Venezuela’s debt also generated significant returns, as yields compressed from 18% to the 7% level that BHEMS’s fundamental analysis determined was fair value for the debt.
The Venezuelan position was exited before Hugo Chavez died, as his ill health created succession risk and political uncertainty over the future of the regime. Taking profits on this trade was not an isolated decision – the fund currently has only around 5% allocated to credit, the lowest weighting in a five-year history that has seen credit make up as much as 60% of the fund’s total NAV. In addition, the fund has started to short some short-dated interest rates, but only in the emerging markets. The risk/reward profile of shorting government debt is much more attractive in emerging than in developed markets, for several reasons. Whereas upward-sloping yield curves turn shorting into a negative carry trade in developed markets, inverted yield curves in emerging markets can create a positive roll-down yield which means that the fund gets paid while awaiting any rate rises. When and if they do rise, rates can re-price much faster in emerging markets – increases of 1% or 2% in the space of a month as seen in September 2011 dwarf the incremental, quarter-point changes that are typical in developed markets. Additionally, the captive demand for government debt created by quantitative easing does not exist in most emerging markets.
Having retreated from credit, one of the higher-conviction views for the fund is that emerging market equities are now the asset class to own. Equities appear cheap in both absolute and relative terms, on a range of metrics. Price to earnings ratios, price to book value ratios, and dividend yields are all compelling. Relative to history emerging market equities are close to a 25-year valuation low, and are one or two standard deviations below averages. Moreover, BHEMS estimates that emerging market equities now trade at a 20/30% discount to developed market equities – but do not believe they deserve any discount, based on fundamental analysis. However, equity holdings in Brazil, China and Korea are not just a value trade. BHEMS hold the view that the global growth cycle is accelerating and could beat consensus expectations – something that could filter through into better corporate earnings.
Strict risk management, overseen by the Brevan Howard risk team, prevents any overly aggressive net long positioning, but the fund currently has 50% allocated to emerging market equities. Other risk controls include liquidity: on average 88% of the fund’s assets have been Level 1 as defined by US GAAP and the fund has never had any exposure to Level 3 assets. The emphasis on liquidity means that the strategy manager, Geraldine Sundstrom, will tend to avoid most of the more esoteric instruments in emerging markets.
Liquid, plain vanilla instruments have delivered average annual returns of nearly 10%. The fund has substantially surpassed its primary performance objective of outpacing a “balanced” emerging markets portfolio that might contain 50% equities and 50% bonds. As with all Brevan Howard-managed funds, downside protection is vital. Focusing on two negative years for emerging markets, the fund made 6.84% in 2008, and its 6.39% loss in 2011 was less than that of the benchmarks.