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Say Goodbye to the Easy Days

May 1, 2012

Times are more challenging for Brazilian fund managers, as LatinFinance’s rankings show. A more flexible buyside must look at a broader scope to hit return targets.

At the start of 2011, Alexandre de Zagottis, CEO at Advis Investimentos, and his two co-heads of investment, Eduardo Bodra and Julio Marote, saw an opportunity to buy options that would come into the money if Brazil reduced rates. This was a contrarian view and the options were cheap.

"The yield curve was pricing in rate hikes, which we too thought might happen, but we also believed that if the external environment deteriorated, this would be a cheap hedge," says de Zagottis, in São Paulo.

"Options were an intelligent way to hedge against the Armageddon scenario in Europe," de Zagottis explains. The bet paid off in spades. The Central Bank aggressively reduced rates from August when the European crisis was worsening. The Enduro fund rose by 11.0% in a month, he notes.

Advis’ multimercado – or mixed asset – fund was up 10.3% in the year and is the best performing multimercado fund in the LatinFinance Brazilian Fund Management Performance ranking. The ranking, complied by LatinFinance and Economatica, is based on a weighted measurement of one-year and three-year performance to year-end 2011, in the debt, equity and multimercado classes. Funds must meet minimum size and asset allocation requirements for inclusion.

Last year was a tough one for Brazilian funds, as the LatinFinance survey shows, though the three-year returns are much healthier. Only one equity and one bond fund in the ranking were in positive territory for 2011. Multimercados fared better with 15 generating positive returns, but only one, Enduro, hit double digits. It’s not surprising, given the US dollar lost 12.6% against the real while the Bovespa index fell 18% in local currency terms.

Weak performance is leading to painful, secular change in the industry. The fat years when managers could rely on sky-high real interest are over, with real rates less than 4.0% today and falling.

"Investors are looking for more performance," says Alberto Jacobsen, executive director at advisor Risk Office in São Paulo. "We saw a lot of redemptions last year. As markets have come back this year, investors have been putting money to work in higher volatility funds."

"Today, you need to set a higher target over the interbank rates of at least 1.0-1.5%," agrees Ronaldo Patah, head of fixed-income at Itaú Asset Management.

Last year was dominated by rate movements. First, the Central Bank ran up rates before taking an axe to them from August. That led to a bumpy ride for bond investors. In equities, managers really need to add alpha as treacherous markets saw index huggers get poleaxed by the slide in larger cap and commodity stocks.

Fixed-income Dives

It’s very much fixed-income that dominates the local industry, including for most multimercado funds.

The first eight months of last year were poor for bond investors as the Central Bank raised rates, which peaked at 12.50%, before the bank reversed direction from August. Since then, rates have come down to 9.75%.

"That has helped the whole asset management industry and investors have piled into fixed-rate bonds, primarily through futures, and started to perform much better," says Jacobsen.

One of the bond managers that navigated these choppy waters with most aplomb is Itaú Asset Management. It has three funds among the top 10 in LatinFinance’s fixed-income category, the only manager to pull off this feat. Itaú is a heavyweight in the asset management area with 300 billion reais under management, of which fixed-income accounts for 120 billion reais, says Patah. The top performing Itaú fixed-income Active fund holds 1.5 billion reais and assets have been growing at close to 20% per year for the last three years, he notes.

Patah’s performance in bonds has been driven by a combination of factors including yield curve plays, inflation-linked bond exposure, and a buy-and-hold strategy for corporate credits. Recently, he has been more successful in trading inflation than the yield curve, he admits.

Patah says it has been difficult to read government and Central Bank policies since the start of the Rousseff government. The bank has used macroprudential measures and seems to be incorporating economic growth in its policy mix, he says.

"Given Brazil’s history of inflation, it is very sensitive for the bank to admit that it is no longer pursuing a pure inflation-targeting mandate," Patah says. The bank has stated that it will bring rates down to 9%, but he wonders if it will stop there.

Patah is buying bank deposit certificates and debentures and even some structured bond products for some portfolios. Today, some 35% of some fixed-income portfolios is invested in corporate credit.

The problem is that "other managers are thinking the same way and corporate spreads on the best names have collapsed thanks to demand, with many yielding just 1% or even less," he says. To boost returns, he plans to launch more aggressive fixed-income funds, taking more corporate risk, being more active in FX and trading more inflation-linked instruments.

It Pays to be Flexible

In the long-only equity space, absolute return funds, which can avoid stocks in the commodities-heavy Bovespa index, are in vogue. Some small and mid-cap funds have done well as have those betting on domestic consumer stocks, which are badly under-represented in the index. It is the nimble and free-thinking fund managers that were the top performers last year.

BNY Mellon is one of them. The manager runs three equity strategies, value, growth, and a small and mid-cap value fund. The BNY Mellon ARX Long Term equity fund that was launched in 2008 belongs to this last group, and is one of the top performers in the LatinFinance equity category.

The small and mid-cap fund can invest up to 20% in larger stocks. That provides flexibility and allows Alexander Gorra, senior investment strategist in Rio de Janeiro, to exploit the valuation opportunities in the discount premium for smaller caps. At times, that can be as much as 60% as it was in late 2008 and early 2009.

"Today the risk-reward picture is tougher and the premium has been shutting down," says Gorra. Indeed, this year’s market rally has Gorra and others wondering how much value there is left in stocks. Today, he has 18% in cash, much higher than the typical 5%. Gorra is tweaking exposures, selectively slicing domestic consumer names, which have performed, and adding commodities, which have taken a battering.

"Retail stocks were up 30-50% over the first couple of months of the year and some are trading at rich multiples of 20-25 times," Gorra says. "We are constructive long term but more cautious on the short term."

For him, credit card companies and shopping malls continue to offer "a top combination of reasonable valuations, good free cash flow and strong dividend yields, at 5% on credit card processors," he says. Gorra sees sweeping changes ahead.

"Brazil is developing a two-speed economy – industrial production should continue to underperform while the service economy should continue to grow strongly," he says.

Octávio Magalhães, partner and CIO at Guepardo Investimentos in São Paulo, runs another successful long-only equity fund that is small and mid-cap focused but has some significant large-cap positions too. The Guepardo institutional fund came fifth in the LatinFinance equity category last year. The absolute return, pure long-only fund uses bottom-up analysis that blends quantitative and qualitative inputs, he says. Since inception in 2001, the fund has annualized 37% performance, versus 18% for Bovespa. The secret lies in very deep analysis of companies and very conservative estimates, he says.

"We purchase only businesses that offer substantial discounts and keep positions on average for 28 months," Magalhães says. The fund blends large caps such as Itaú, which it snapped up on the cheap last August, and BR Foods which it bought in the first half of 2009.

Magalhães also buys small caps, such as medical equipment supplier Kremer. When it bought into the stock at the start of 2008, Kremer had a market cap of 200 million reais with 180 million reais in cash, valuing the company at just 20 million reais compared to Ebitda of 40 million reais in one year.

"We stayed with the company and improved management and today it is generating annual Ebitda of around 100 million reais," Magalhães says.


Multimercados in general performed not far from the CDI benchmark. Foreign investors often erroneously translate multimercado as hedge funds, but mostly are conservative, using fixed-income with just a dash of currencies and equities to pep up returns.

Today, they are having to hedge more intelligently, push deeper into global rates and currencies and add equities. Macro funds have been the top performers in the multimercado space as the dire performance of equity markets hits the generally long-biased universe of long-short funds.

Advis Investimentos’ Enduro fund leads the pack on a one-year basis (the fund does not yet have a three-year record). The boutique manager emphasizes a global approach, strict risk controls and a limit to downside, says de Zagottis. Long positions are hedged, typically through the options market, and the fund arbitrages both inter and intra-asset classes and geographic markets, he notes.

Correct calls on markets and downside limits are behind performance, says De Zagottis. Not surprisingly, the manager has quickly built up assets and today has 5 billion reais across three strategies, global macro, Brazilian macro and equities. Multistrategy Enduro is a Brazilian macro fund.

De Zagottis questions the market consensus on higher rates today with the Brazilian forward curve pricing in hikes at the start of April of up to 200 basis points from the start of 2013.

"It’s possible that inflation picks up and rates do go up ," de Zagottis says. "But the Central Bank is dovish and there’s a political commitment to reduce rates and boost growth so it is hard to see such a rapid rate hike."

If the external scenario worsens, the bank may even reduce rates, he thinks. As his dovish position is contrarian, he is finding options cheap and has been buying.

"You have to be patient as an investor. We have made money on the curve but sometimes you have to wait for a year," de Zagottis says.

Advis is also long Brazilian equities and the MSCI emerging markets index while the manager has been reducing short positions on Spanish and Italian stock indices. In currencies, de Zagottis is long the US dollar against the euro and long the real and other commodity currencies against the US dollar. Managers are increasingly having to look for alpha as markets have become so free of trends. "It has been difficult to spot beta trends over the last year," he says.

At the other end of the size scale lies BTG Pactual Asset Management. It is the leading asset manager in the multimercado space with 45 billion reais in such assets under management, and the sixth largest asset manager in the country, says João Scandiuzzi, its chief strategist. The BTG Pactual Local Multimercado fund came fifth in the LatinFinance rankings.

The BTG fund is a freewheeling instrument that plays on the curve and increasingly with corporate and structured credits, a growing array of currencies and dabbles in equity markets too.

BTG has been moving into private credit but, "exposure tends to be very conservative and in very liquid names, including deposits of first line banks, which yield 107% of the overnight CDI. Returns are largely played out through the reduction in spreads," Scandiuzzi says.

He agrees with de Zagottis that the futures market is too hawkish on the Central Bank. The bank may take rates down further than the 9% it has already signalled, he believes. Sovereign trades are generating less upside. At the same time, the curve is becoming very sensitive to macro news and even shadows the US Treasury curve, he says.

He has been more opportunistic than strategic in FX exposures. The capital control interventions by the Central Bank allow short-term gains but make reading trends difficult, he says, echoing the comments of Itaú’s Patah. Overall, he expects a stronger US dollar but "this is not the environment we had between 2004 an 2008 where you really had trends to play with," he notes.

In the equity portfolio, Scandiuzzi says he is more willing to bet on the reacceleration of the economy.

"It might take a while as credit growth is slower because delinquency rates are higher and banks are not yet passing on lower rates to customers, but they will," Scandiuzzi says. He sees faster GDP growth in the second half with domestic names, retail companies and some financials stocks benefitting.

"Our philosophy in equities is to have very concentrated portfolios that are not correlated to the Bovespa index and are focused on alpha generation," Scandiuzzi says.

New ideas

The relentless decline in interest rates means the low-hanging fruit has been picked in the asset management industry. Low volatility funds are passé.

The new appetite for risk is shaping the development of new products. Brazilian managers are turning to more illiquid areas such as private equity and real estate, says Joaquim Levy, chief strategy officer at Bradesco Asset Management. The new generation of products will look more like those in developed markets. Private equity, credit, agro and infrastructure are all proving popular with investors, says Levy. Pension funds are also increasingly prepared to look at higher volatility and illiquid instruments, he says.

That is forcing fixed-income funds deeper into the corporate market and some are even starting to dip their toes into Brazil’s fast-growing structured products market. Equity managers are having to move away from the commodities-heavy Bovespa index and identify pockets of alpha and overlooked value. Multimercados need to use a combination of these strategies, soup up equity holdings and step up fixed-income and FX risk.

Finally, Brazilian markets are sorting out the wheat from the chaff. LF

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