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October 30, 2006 8:04 pm

John Dizard: Defying the mediocrity of the hack farm

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There was a time not long ago when the emerging markets debt world was a haven for scholars-turned-mercenaries, danger junkies, CIA contractors in signature wash-and-wear Brooks Brothers’ suits and other really strange people. It was not just entertaining, though. You could make real money at it, or “alpha” as the marketers call it now.

No more, sadly. From having some of the more interesting people in the financial markets, emerging markets has turned into a hack farm. Instead of picking up cheap paper that no one else would spend the time to analyse, most EM practitioners are leveraging up risk. Then, when things start to turn, they all try to get out of the same position at the same time. To compare them to lab rats in a maze is to defame the rats.

This is true of all markets to some extent but EM debt has become an unusually momentum-driven world.

Still, though, money piles into the sector. So far this year the EMBI-G bond index, a broad measure of emerging market bonds, is up about 5.8 per cent. That is not much compensation for taking large bets on Latin American elections.

There are exceptions to this decline into mediocrity, though. One is FH International Asset Management, based in Harrison, New York, run by Eric Hermann and Steve Landis. A relatively small fund compared with the huge closet indexers, FH has about $220m in assets under management in various vehicles.

Rather than front-run momentum, it applies the classic techniques of looking at EM paper through a jeweller’s loupe, then X-raying it to see what is underneath. It works pretty well.

Since March 1998, a period that included several EM crashes, FH has earned a compounded rate of return of more than 22 per cent, compared with 10 per cent for the EMBI-G (and 2.5 per cent for the S&P 500 index). This year, its main hedge fund, the FH Emerging Markets Debt fund, is up 7.3 per cent, a fairly good margin over the index.

FH’s long-term average return is somewhat less volatile than the EMBI-G index although the EM world has its ups and downs. Its best year was 1999, in which it had a 97.76 per cent return; the worst was the Russia crash year of 1998, in which it incurred a 2.28 per cent loss. “I’m most proud of our results in 2002 (up 36.18 per cent) and 2003 (up 45.36 per cent),” Mr Hermann says. “We had long-term deals involving distressed African sovereign credits.”

The Sharpe ratio, which compares return with volatility, is a respectable 1.25 for FH over its history compared with a modest 0.42 for the EMBI-G and a negative 0.27 for the S&P 500.

Mr Hermann is best known in the EM world as an Africa expert, having spent a couple of decades working the continent, both as a banker and as an investor. Contrary to the present conventional wisdom in the EM world, he is underweight in Africa right now. Why?

“Most of what people are doing in Africa now is in local currency instruments, but I am not convinced that the reward compensates for the risk,” he says. “We are going to grind our Africa exposure back up but it will almost certainly be in hard currency instruments. If we are going to do something exotic, it won’t be in the currency but in working on challenging documentation. We love credit risk where we have instruments we can get cheap because people won’t take the trouble to actually read the agreements.”

Given the weight of money that has moved into emerging markets over the past few years, you would expect the interesting opportunities would be largely arbitraged away, but Mr Hermann says this has not happened.

“There are lots of large players, for example, who only play in bonds, not loans. A bond trader will start off by asking: given the bonds out there, what can I trade? An emerging markets trader will say: these are the interesting situations out there, what are the instruments that will give me good returns? The problem with the local currency stuff is that, yes, it pays a higher yield but, when they exit, the turnstile is rusty and small.”

Rather than going in or out of on-the-run Brazilian paper, the FH partners look to issuers such as Paiton Energy Funding BV, which is the debt behind an Indonesian electric generator. Paiton has a 9¾ per cent issue due in 2014, which currently yields about 80 basis points more than the Indonesian sovereign issues. Mr Landis says: “The government of Indonesia needs more generation, so they don’t want to alienate the private generating companies now. Paiton buys fuel from one government company and sells power to the government distribution company.”

So it is only a millimetre removed from being government risk itself. The interest payments are partially guaranteed by the Japanese government export bank. As Mr Hermann and Mr Landis have changed their views on the interest rate curve, they have switched between Paiton’s floating rate loans and the fixed rate bonds.

They make use of the credit default swaps and swap indices in more liquid markets. “It’s been a great tool for sovereign credits,” Mr Landis says, “but the markets for CDSs for corporate credits are not as liquid.”

The FH partners are also doing well-documented dir­ect dollar loans to Brazilian beef companies and taking exposure in Mexican home construction and mortgage finance companies. Their country weightings are heavy on Russia, Argentina, Brazil and Indonesia.

“Right now we have a lot of special situations [documentation-intensive, event-driven positions],” Mr Hermann says. “But we aren’t always positioned that way. For example, in 2002 and 2003 the market was flying, so being long liquid sovereign paper made a lot of sense.

“The fact that we are nervous now about the overall direction of the market is reflected in our low allocation to the market directional bucket. If people are taking leveraged bets on their conviction about market direction, when things shift, half will look like heroes and half will be out of business. We are more humble and we plan to be around for a long time.”

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