Brazil Hedge Funds Beat U.S. Competitors by Investing in Bonds

Hedging-Griffo's Luiz Paulo Parreiras and Luis D'Amato
Hedging-Griffo strategist Luiz Paulo Parreiras, left, and Luis D'Amato, head of institutional products, at the company's office in Sao Paulo. Photographer: Gabriel Rinaldi/Bloomberg Markets

They arrive every week, in ones and twos and groups of 10, some of them coming straight from Sao Paulo’s Guarulhos International Airport. These investors head for the dark-wood halls of Credit Suisse Hedging-Griffo as supplicants, asking to put their millions of dollars into one of the world’s top-performing hedge funds.

The answer from the fund’s managers is often a polite but firm no. Hedging-Griffo’s Verde fund has returned an annualized average of 33 percent since 1997. One American offered to sign a contract that wouldn’t allow him to ask for his cash back for three years, says Luiz Paulo Parreiras, strategist for the firm.

“Pension funds, endowments, sovereign-equity money -- we’ve turned all of them down,” he says. The money managers are concerned that if Hedging-Griffo’s $8 billion hedge fund becomes too large, its trades may move Brazilian markets, Parreiras says, Bloomberg Markets magazine reports in its July issue.

Hedging-Griffo’s high returns during the past decade lead the pack in Latin America’s largest country, and other Brazilian hedge funds -- many of them still open to new investors -- aren’t far behind. Americans and Europeans are beginning to notice.

The Eurekahedge Latin American Onshore Hedge Fund Index -- 90 percent of which is composed of Brazilian firms -- had an average yearly return of 20 percent from 2001 to 2010, the best in all regions of the world, according to Eurekahedge Pte, which has offices in London, New York and Singapore.

Mostly Bonds

The irony is that trading strategies by most Brazilian hedge funds are similar to those of indexed mutual funds. Brazilian managers put almost all of their money into bonds and stocks. Brazilian regulators call hedge funds multimercado, or multistrategy, firms to differentiate them from mutual funds.

Unlike the unregulated pools of capital in the U.S., hedge funds in Brazil report their asset values daily to regulators. They also have to disclose their holdings and typically must be able to meet redemptions within days of when investors ask for their money, inhibiting them from making many risky bets.

That means Brazilian hedge funds are relatively easy to manage, says Simon Nocera, co-founder of San Francisco-based hedge fund Lumen Advisors LLC and a former economist at the International Monetary Fund.

“All you have to do is buy the Bovespa stock index and government bonds,” he says. “It’s not like you have to be superactive or a great trader.”

Top Returns

Investors aren’t complaining. Brazilian funds have been profitable because in the past 10 years, the nation’s government bonds and stocks have beaten the returns of most indexes in the world. Fiscal austerity, record exports and rising incomes have fueled the boom.

A two-year Brazilian government bond has posted an average yearly return of 17 percent since 2001. Brazil’s Bovespa stock index rose by 16 percent a year in that period compared with a 1 percent gain for the entire period by the Standard & Poor’s 500 Index.

Globally, hedge funds gained 11 percent annually in that period, according to Eurekahedge.

Brazil’s economy grew 7.5 percent in 2010, its fastest pace in two decades. The heated growth is creating a new class of wealthy investors. From 2006 to 2009, 38,000 Brazilians became millionaires in U.S. dollars -- that’s 26 every day -- according to Bank of America Corp.’s World Wealth Report.

In October, Highbridge Capital Management LLC, the New York-based hedge fund controlled by JPMorgan Chase & Co., spent an undisclosed amount to buy what it says is a controlling stake in the $6 billion fund management firm Gavea Investimentos Ltda. in Rio de Janeiro.

New Funds

Brazilian analysts, traders and former investment bankers have opened 31 new hedge funds during the past year, according to data from Sao Paulo-based research firm Economatica. The country has 462 hedge funds.

As the economy expanded, the excess of cash spurred accelerating inflation, along with a 39 percent increase in the value of the real against the dollar, in the two years ended on April 29.

Brazilian bonds rallied as the nation received its first-ever investment-grade rating in 2009. Brazil’s central bank haS raised overnight bank lending rates three times this year, to 12 percent, in an effort to cool off the boom.

The skyrocketing currency and faster inflation raise questions about whether returns will continue at the same pace, says Jim O’Neill, chairman of Goldman Sachs Asset Management in London.

‘Brazil Kit’

“It’ll be hard to match the past decade,” he says.

The common Brazilian hedge-fund strategy, dubbed the “Brazil kit” by fund managers and traders because it’s so simple, holds about 66 percent in bonds and most of the rest in stocks, along with some bets on currency or Brazilian interest rates, regulatory filings show.

Investors pay Latin American hedge funds the same fees that are common in the U.S. and Europe. They charge an average of 1.88 percent of assets and 20 percent of profits, according to Eurekahedge.

Wealthy Brazilians demand that managers consistently beat returns on government bonds, says Marcelo Mesquita, co-founder of Leblon Equities Gestao de Recursos Ltda., a hedge-fund and private-equity firm in Rio. Many fund managers are so concerned they’ll trail bond profits that they miss the best equity bargains, he says.

“They shouldn’t be getting paid the 2 and 20 if they aren’t taking risks,” Mesquita says. “You pay someone to judge the risks to get a higher return.”

Few Choices

Strategists have few choices in Brazilian stocks. The Bovespa stock exchange lists 467 companies compared with 5,700 traded in the U.S. Ten stocks make up 50 percent of the market value of the Bovespa index.

That limits fund managers’ choices, says Tony Volpon, Latin America strategist at Nomura Holdings Inc. in New York.

“They’re trapped in a little box,” Volpon says. “So it’s difficult to differentiate themselves because everyone does the same thing.”

That’s not a concern for many investors. Cesar Stange, partner at Gaia Capital, a wealth management firm in Buenos Aires, says he’s put client money in Brazilian hedge funds for seven years.

“The spectrum of strategies is smaller, but there are some very clever managers,” he says. “You put smart people together with a strong market and the results are great.”

Offshore Funds

Some Brazilian managers have opted to take more risks by incorporating their hedge funds offshore. That allows them to get around government regulations. Sao Paulo-based Tarpon Investimentos puts its money mostly in stocks of companies with strong growth potential, says Jose Carlos Magalhaes, who founded the firm at age 24 in 2002.

Investors in its offshore fund agree to allow Tarpon to hold their money for two years. The fund has beaten most hedge funds in Brazil in the past nine years. Tarpon HG Fund-A posted a five-year annualized return of 30 percent from 2005 to 2010, topping the February Bloomberg Markets ranking for Brazilian offshore hedge funds larger than $1 billion.

Magalhaes, known as Zeca, dresses casually in the office, as does Hedging-Griffo’s Parreiras and most fund managers in Sao Paulo. The usual attire is a blue button-down shirt, with its sleeves rolled up, and Diesel jeans or dark slacks. In Rio, some strategists work in beach garb, says Claudio Andrade, co-founder of hedge fund Polo Gestao de Recursos Ltda.

‘Be Comfortable’

“We work hard here,” he says, wearing brown moccasins and no socks. “A lot of times they spend more time here than at home, so I want everyone to be comfortable.”

Regardless of where Brazilian hedge funds are registered, not one collapsed during the global subprime financial crash that began in late 2007, says Maria Helena Santana, president of regulatory agency Comissao de Valores Mobiliarios in Rio.

That crisis -- caused largely by the $2.5 trillion that banks, insurance companies and hedge funds held in securitized subprime debt -- took down 2,494 funds globally in 2008 and 2009, according to Chicago-based Hedge Fund Research Inc.

Unlike the U.S., Brazil requires managers to report to independent risk assessment companies, in some cases every week. Bank of New York Mellon Corp. is the one most often used.

“It makes all the difference if you have more transparency,” says Luis D’Amato, head of institutional products at Hedging-Griffo. “In the U.S., whenever you got the info, it was too late.”

European Funds

Some U.S. and European hedge funds are following Brazil’s lead. The European Commission is using regulations similar to Brazil’s for a new class of hedge funds known as UCITS. The rules for UCITS require managers to report investment holdings and restrict the use of loans to buy securities.

These funds must allow clients to withdraw assets in as little as one day. UCITS (Undertakings for Collective Investment in Transferable Securities) tripled in assets to $90.5 billion last year, according to Hedge Fund Intelligence.

John Paulson’s Paulson & Co., based in New York, and David Harding’s Winton Capital Management Ltd. in London are among the hedge funds that started UCITS last year. The funds are registered in Europe.

Brazilian regulation forces managers to be more aware of risks, Hedging-Griffo’s Parreiras says. Luis Stuhlberger started the Verde hedge fund in 1997. Four years later, strategist Parreiras began working with Stuhlberger as a 21-year-old intern after he graduated from the University of Sao Paulo as an engineer.

Young Managers

In 2007, Zurich-based Credit Suisse Group AG bought a majority stake in Hedging-Griffo for 421 million Swiss francs ($364 million).

“They try to hire young people,” Parreiras says. A slim man who wears wire-rimmed glasses, Parreiras talks casually in the office. “I’m really like the new generation within Credit Suisse Hedging-Griffo,” he says.

In the 1990s, the proprietary trading desks at Brazil’s largest investment banks, such as Banco Garantia SA and Banco Pactual SA, trained the country’s top traders.

Hedging-Griffo, Brazil’s largest hedge fund, differs from others because of its long track record, Parreiras says. The Verde fund is one of the oldest in Brazil. It has weathered several crises, including the 1998 financial contagion that started with Thailand’s currency devaluation and Argentina’s bond default in 2001.

“Running risk within that environment proves that people have to work for the money they are making,” Parreiras says. “You can’t just buy a ‘Brazil kit’ and go home.”

Large Enough

With $8 billion under management, the hedge fund can’t get any bigger without moving bond markets, Parreiras says.

“If we were bigger, it would hinder our ability to move in and out of markets,” he says.

Newer, smaller funds have had similar success. Zeca’s Tarpon is one of them. At age 17, Zeca, whose cousin was a stock trader, began putting his savings into equities, he says.

“I started with $1,000, and then $5,000, then $20,000 and then $50,000,” he says. As he made money, he convinced his family and friends to let him manage their cash, he says.

In the throes of a financial distress in Brazil in 2002, triggered by Argentina’s default on $95 billion of foreign debt, Zeca says he decided to take a risk. He knocked on the door of his boss, Ricardo Semler, chairman of Semco SA, a maker of mechanical parts, and asked for money to start a hedge fund.

‘Natural Birth’

Zeca says he wanted to start a fund because stock prices were too inexpensive to pass up.

“This was a natural birth,” Zeca says. Semler invested about $2.2 million in Tarpon, Zeca says. That turned out to be a profitable decision. Semler’s money has grown 17-fold from the fund’s inception to mid-May. Tarpon is accepting new investors only in offshore funds.

One of Zeca’s first investments was in Sadia SA, a Brazilian poultry processor. The Concordia-based slaughterhouse was moving into the frozen-food market, offering products such as fusilli pasta with sausage, ready-made burgers and turkey-breast pies.

Zeca had five Tarpon analysts studying how this transition would bolster cash flow, says Eduardo Mufarej, chief executive officer of Tarpon.

Keeping analysis narrowly focused is one of Zeca’s philosophies. Almost everyone, including himself, is exceptional at no more than 5 percent of the things he or she does, Zeca says. They’re below average at the rest, he says.

Big Stake

“I don’t believe in great ideas,” he says. “We are not Thomas Edison inventing light bulbs.”

By July 2004, Tarpon had funneled 85 million reais ($52 million) into Sadia, which represented 35 percent of the hedge fund’s assets. Brazil doesn’t restrict the amount that a fund can put in one company. The young money managers, all under 30, began to get to know the Fontana family, Sadia’s controlling shareholders, Mufarej says.

By February 2005, Tarpon had decided Sadia made bad decisions when it started exporting and spending too much money to increase production capability, he says. So it sold its shares in the company, making five times as much as it had paid to buy them, Mufarej says.

Three years later, as stocks plummeted, Tarpon began seeking bargains to spend its cash on. It took another look at Sadia. The company had made wrong-way currency hedges leading to 760 million reais in losses. The stock fell by more than 70 percent in two months after the company announced those trading results on Sept. 25, 2008.

World’s Largest

Sadia accepted a takeover offer in May 2009 from competitor Perdigao SA. Zeca immediately asked his staff to drop everything and analyze projections of the merged companies, he says. Two months later, Tarpon was among the largest investors in a share sale valued at $2.8 billion as part of the takeover.

The new company became Brasil Foods SA. By December 2010, it was the world’s largest poultry exporter, according to data compiled by Bloomberg. As of March 31, Tarpon owned Brasil Foods stock valued at $1.1 billion, its biggest investment, representing about 32 percent of the firm’s assets.

As Tarpon makes big bets on one company, the Polo fund in Rio takes a different approach. It seeks to exploit stocks with values that swing because of fast-moving situations such as potential acquisitions, policy decisions or crises.

Andrade, co-founder of the $1.3 billion fund, named it in 2002 after the Portuguese word for pole -- as in North or South Pole -- in order to remind himself to look at the other side of the obvious, he says.

Third Highest

The Polo Fund-Series 1 posted an annualized return of 21 percent during the past five years, the third highest in the 2011 Bloomberg Markets hedge-fund rankings.

“We don’t need to do the Brazil kit; there’s other people that do that much better than us,” Andrade says.

A newer, successful Rio-based fund is Leblon Equities, which started in the same month as the collapse of Lehman Brothers Holdings Inc., in September 2008. San Francisco-based Farallon Capital Management LLC, which manages $20 billion and was founded by Tom Steyer, watched the Brazilian fund and wasn’t deterred by declines in stock markets around the world.

It bought a 12 percent stake in Leblon four months after the firm opened. The stock-only shop managed $350 million as of May 11, up from $10 million when it began, says Leblon co-founder Mesquita, who was formerly head of Brazil equities at UBS AG.

“Equities are where the growth is in Brazil, and if you have a good project, the money is there,” Mesquita says.

Whether money managers followed the traditional strategy of buying mostly government bonds or put their assets into stocks, Brazilian hedge funds have done little wrong in the past decade. As investors around the world hunger to buy in, inflation and soaring currency values are likely to force Latin American strategists to expand the tool collection in their Brazil kit.

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