Finding alpha in emerging markets

Originally published in the April 2010 issue

The following is a sponsored statement from GAM

While the memory of 2008’s financial crisis will be enough to give most asset managers nightmares for years to come, GAM’s Paul McNamara has reason to remember it differently. “2008 was the year in which we were able to clearly demonstrate how different we are to our competitors,” he says. “At the time many of them were leveraging into high risk, illiquid positions (and reporting strong returns) and as a result most of these managers suffered badly when the crisis hit. Our approach is to keep things as simple and liquid as possible, and to make minimal use of leverage.”

This approach has served the fund well: since its inception in November 2004 to 28 February 2010, the US dollar class of GAM Emerging Market Rates Hedge Fund, the fund McNamara co-manages with Caroline Gorman, has returned an annualised 14.0%.1 During 2008, when emerging markets’ hard-currency debt declined in value by more than 33%, the fund gained 8.3% 1, significantly outperforming most of its competitors.

“The fact that we were less leveraged than our competitors meant that we did not get squeezed as much by the huge wave of margin calls that inevitably came when the global economy collapsed,” McNamara says. He recalls that the beginning of 2008 anybody wanting to sell insurance on, say, Vneshtorgbank in Russia would have to post 5% of the nominal in margin, whereas a few months later, they would have to pay 100%. “You would have had to close out your trades just to meet the margin calls, which many funds found very difficult because they were so highly levered. However, we were never in a position where we were unable to close out trades.”

Liquidity key to risk management
The only way to reduce risk meaningfully is through liquidity, McNamara insists. “You can try to manage risk via a relative value approach,” he says, “whereby you go long one and short the other and assume that if the market blows up the short will look after you, or else buy put options and hedge the trade somehow. We prefer simply to keep the positions as small and liquid as possible, and generally to stick to the vanilla end of the spectrum in terms of instruments.” He does not believe that risk can be managed statistically. “We’re downright contemptuous of VaR,” he says. “Statistical approaches to risk do more harm than good.”

Such has been the success of GAM Emerging Market Rates Hedge Fund that GAM is due to launch a UCITS version. The new fund will adopt a similar fundamental, value-based approach to the offshore fund, but as a UCITS fund it will offer daily dealing on five days’ notice and will be subject to restrictions on the type of investments that can be made. McNamara joined Julius Baer Investment Management (JBIM), which later became Augustus Asset Management Limited and is now part of GAM, as an economist in 1997. This came after two years as a lecturer in economics at the University of Warsaw, where he first gained direct exposure to emerging markets. “It wasjust at the end of the great European convergence trade, and JBIM was thinking, ‘we’ve done Italy and Spain – where do we go next?’” McNamara says. His first role at JBIM was managing government bond portfolios that would otherwise have been invested in the UK, US, Spain or Portugal. “We did a little marginal crossover into Poland, Mexico and South Africa, and then suddenly these markets started developing very quickly. The Asian crisis gave them the impetus to start developing proper capital markets of their own rather than just issuing in dollars, so it was very much the right place at the right time.”

Emerging markets come of age
In 2004, JBIM decided to split off a new fund (later renamed GAM Emerging Market Rates Hedge Fund) based on its emerging markets exposure within an existing diversified fixed income fund. However, the environment in which the fund was launched was in sharp contrast to the one in which it operates today, says McNamara. “There had just been a general election in Brazil, during which period everybody was convinced that the country was going to default. There had already been crises in Asia, Russia and Argentina, and many people were ready to give up on the whole asset class – but of course that turned out to be the backdrop for the biggest rally emerging markets have ever seen.” From the beginning of 2004 until the end of 2007, the JP Morgan Government Bond Index-Emerging Markets gained 77.8% in US dollar terms, a compound average annual growth of 15.5%.


Fast-forward five years and the image of emerging markets could not be more different. Rather than being seen as a high-risk/high return strategy, emerging markets are feted for their strong balance sheets and conservatively-managed banking systems. “It is only a small exaggeration to describe emerging markets as a safe haven,” McNamara says. “What people are really worried about is developed markets. If you look at the BRIC credit spread against the PIIGS, they’ve traded through each other – for the first time in history the big emerging markets are seen as a better prospect than the small developed markets.”

GAM Emerging Market Rates Hedge Fund utilises a combination of directional and relative value trading, with a strong bias towards the former. The fund invests in both local and hard currency emerging market debt instruments, as well as undertaking controlled currency plays, with the aim of enhancing returns in a controlled risk environment. McNamara says that when choosing trades, he and Gorman focus much more on value than momentum. “We will do some counter-momentum trading to take some of the volatility out of the fund, but the bottom line is that we look at the markets and say, “this is cheap, this is expensive”, and so on.” He says that although the fund incorporates some relative value trading, this is usually kept to a minimum because the size of the trades usually required for relative value investing invariably necessitate the use of leverage, which would eat away at his team’s ‘keep it simple’ approach. “We try not to finesse it too much. Of the various freedoms you get from being a hedge fund, the key one for us is long/short. We don’t do a lot of leverage, and we don’t do a lot of exotic derivatives.”

Team approach
McNamara’s team currently consists of himself and fellow investment manager Caroline Gorman, and they will be joined in April by a third member, Denise Prime. Their approach is macro-focused and while collaborative, is based on the principle of maintaining clear lines of responsibility. Either McNamara or Gorman decides whether or not to put a trade on, when to take it off, whether to set a stop-loss, whether to double-up, and so on. “There’s a clearly identified point of responsibility for each trade.” Although they sometimes disagree, he and Gorman are “very rarely at loggerheads”, he says. “When there is a conflict of opinionwe tend to go with whoever has the strongest conviction.”

McNamara and Gorman are situated on the same floor as the rest of the former Augustus fund managers who joined GAM when it acquired the specialist fixed income and foreign exchange company in May last year. “We all sit in one big room and basically bounce ideas off each other all day long,” says McNamara. “As sad as it sounds, we are genuinely interested in this stuff. It’s a very good environment because there is such a range of people, from right-wingers to liberals. It tends to mean we get a very robust analysis of ideas.”

With regards to emerging markets, these ideas are no longer as easy to find as they have been in the past. The rapidly changing dynamic between developed and emerging markets, combined with fewer obvious pricing anomalies, means that emerging market investors are having to refine their approach in order to continue generating strong returns. According to McNamara, there has traditionally tended to be two main types of opportunity in emerging markets, both predicated on crises in specific countries or regions. The first tends to arise when a country is priced for years of stability when it in fact has serious problems under the surface, thereby presenting a clear shorting opportunity. “Ukraine was a good example of this in 2008, as was Russia later the same year. These were both countries which were clearly overvalued even though their banking systems were sucking in far too much foreign capital and lending them to dodgy projects.”

The second traditional emerging market opportunity is the flipside of the first, McNamara says. “Historically, the great long emerging market stories have been about getting in soon after a crisis. If you put money into Argentina within six months of the devaluation of the peso in 2002, following the government default and amid the biggest civic, political and economic crisis ever faced by a peacetime country, then you would have made a 250% return over the next six months.”

Seeking new opportunities
But the 2008 economic crisis has radically altered the global economic landscape, possibly forever. While growth prospects in emerging markets in the near-to-medium term look reasonable, the developed world looks set to struggle with anaemic growth at best for many years to come. “The macroeconomic situation in emerging markets looks very, very solid compared to elsewhere. Developed world countries have had a balance sheet recession – they’re mired in government and private debt and their banks are develeraging, which means slow growth for a long time. Emerging markets, by contrast, have had a typical cyclical recession – their export markets have had a big shock and they were also hit by some of the repercussions of the collapse of Lehman Brothers on the international payment system. We believe these countries will be back to trend growth reasonably soon.”

All this means that the key question facing McNamara and his team is no longer – as it has been in the past – whether to be short or long emerging markets. Rather, it is whether to be long emerging markets and short the developed world, or just plain long emerging markets. “We prefer to have a short on the developed world because we think it’s a better risk/reward trade, although the jury is still out on whether it is a better pure reward trade. If you look at what’s happening in Greece, and at the UK’s various problems and what’s happening in the US mortgage market now that the Fed is stepping back from quantitative easing, I think there’s enough to justify being short the West.”

However, despite the changing dynamics of the environment in which he operates, McNamara has no plans to change the fundamentals of his team’s approach. “Some people might like to see more volatility in the portfolio, others might like to see more relative value or leverage,” he says. “But we’ve built a strong track record doing things a certain way. Our approach is to say, ‘this is what we do, this is what we’re good at, and these are the returns that it has produced’. And I think there will continue to be a market for that.”

1. GAM Emerging Market Rates Hedge Fund has claims against Lehman Brothers International (Europe) Limited (LBIE) which amounted to 22.1% of the fund as at 1 December 2008 and which have been segregated into special L class shares. The L class shares do not include certain securities custodied with LBIE, the value of which is expected to be recovered in full. Performance of the L class shares (-96.0% from 1 December 2008 to 28 February 2010 for the USD class) is excluded from performance information otherwise provided for the fund.