Alternative Brazil

As a matter of law, hedge funds in their traditional sense are banned in Brazil. The use of investment tools with the high level of liquidity and diversification that are required by hedge funds to achieve their objectives is strictly regulated in Brazil. Funds (except for private capital funds, accounts receivable, and real estate transactions) are only allowed to acquire assets registered with over-the-counter (OTC) trading systems or stock exchanges, and may not acquire shares from private funds or those that are not quoted on the market.

Therefore it is the so-called multimercado (multi-market) funds that come closest to a hedge fund in Brazil. These structures are allowed to invest in more than one class of asset, and the level of diversification available to them is higher compared to other types of funds. However, not even multimercados can invest in unlisted assets, funds, real estate or derivatives that are not registered with the stock exchange or OTC markets.

Yet there is some sort of exception: if a multi-market fund operates with qualified investors only, its strategy may include transactions with direct investment funds and other classes of assets banned under Rule 409/04 of the CVM (Comissão de Valores Mobiliário), the Securities and Exchange Commission of Brazil.

Today there are 76 hedge funds and seven funds of funds in Brazil. They manage nearly $126 billion. Over a period of seven years (2004–2011), hedge funds showed 1003% growth denominated in Brazilian Reals (approximately 1020% in U.S. dollars). For the sake of comparison, fixed income funds showed only 22.26% growth over the same period, while the funds that invest in shares grew by 177%.

Hedge funds represent the fastest-growing industry in Brazil’s securities market. This phenomenon is driven by two main factors: lower interest rates, and a great number of independent investment management companies not linked to any Brazilian or foreign banks.

The overnight rate (SELIC – Brazil’s Special Clearance and Escrow System), which was in excess of 40% in 1999, went down to 12% in 2007 and dropped to a mere 8.5% by August 2013. Even though interest rates in Brazil are among the highest in the world, this significant yet stable drop had a serious impact on the state of the country’s economy. One of the consequences was a decrease in the profits of fixed income funds that invested a majority of their assets in sovereign bonds. Brazilian investors realised that the new market conditions spelled more risk for them if they wanted to retain the same level of income; this ushered in a legitimate increase in investments in hedge funds.

Strategies

Brazil’s industry cannot boast a multitude of different investment strategies: 12 hedge funds use multiple strategies, 15 gravitate towards micro investments, and one opts for targeted investments in the market for fixed-income instruments. The remaining investment managers tend to lean towards hedged positions in shares. This all leaves very little room for investment manoeuvring in Brazil. For instance, there are 5,700 publicly traded companies in the United States, whereas Brazil boasts only 467. Ten positions account for 50% of the entire market value of Bovespa (the São Paulo stock exchange).

Therefore, over time, the following overall approach has been developed. Managing companies generate their portfolios based on the so-called ‘Brazilian package’ principle, with most of their assets invested in fixed-income sovereign securities. They then open their positions in foreign exchange, bonds and Brazilian shares. This strategy spells low liquidity, yet it brings good profits thanks to high interest rates.

This situation was brought about by the fact that, historically, levels of volatility and inflation on the Brazilian market have always remained very high, and Brazilian investors do not agree with having their money blocked for long periods of time. Therefore many funds have to provide their clients with daily liquidity, which does not enable them to use more flexible strategies and resort to non-liquid positions.

External investors, attracted by impressive growth and income levels, battle for an opportunity to invest with Brazilian hedge funds, often agreeing to have their money blocked for two to three years. However, the market in Brazil still remains relatively close-knit. Size literally does matter here: the largest funds in the country are afraid that if they continue to increase their assets, ultimately their operations may distort the markets. That is why pension funds and endowments – not to mention private investors – are often rejected by the large hedge funds.

Brazil’s securities market is one of the safest and most transparent in the world. It is virtually impossible to hide anything from the regulatory bodies and investors

Regulation and reporting

In many other countries, governments treat hedge funds with thinly veiled contempt at best; Brazil’s government is certainly much friendlier. Hedge funds in Brazil are viewed as a source of investment in the private sector.

One of the reasons behind this attitude probably lies in the fact that alternative investment funds are allowed to take banking loans for a limited time only and subject to huge interest rates, which prevents them from accumulating liabilities that would be many times greater than their assets. Hedge funds tend to use more risky instruments compared to other types of funds; however, in Brazil, the industry’s safety level is much higher than in other countries.

The country’s securities market is one of the safest and most transparent in the world. It is virtually impossible to hide anything from the regulatory bodies and investors. All funds operating in the Brazilian market are obliged to submit information to the CVM on the net value of their assets on a daily basis, along with monthly reports on the state and composition of their portfolios. This information is published on the CVM’s website and is available to the public. The CVM also maintains strict requirements with respect to the level of liquidity, susceptibility to various risks, and adjustments and recalculations of various assets and their net value. Investment managers disclose their positions every month, which makes this market far more transparent. This indicator is several times greater than in the United States, where such information on positions is submitted to the Securities and Exchange Commission every six months. Further, in Brazil all oversight, regulatory and administrative functions are performed by different organisations.

This form of regulation protects the industry and at the same time makes its life more difficult. Given such a degree of transparency, everyone knows what is going on in their competitors’ back yards, although the market’s close-knit nature and its small size also play a role. Investment managers simply do not have that much leeway, so they all do pretty much the same thing.  

Eugenia Slouchak is Managing

Partner at Europe Finance.