Can Hedge Funds profit from Emerging Markets?

With countries such as Ecuador and Argentina feeling the pain of the pandemic, is this a new business opportunity for Hedge Funds to profit from?

As the coronavirus pandemic continues to wreak havoc across the global economy, hedge funds are gearing up for debt restructuring projects for both governments and businesses in emerging economies. Hedge Funds earn money from restructuring debt and providing alternative sources of financing. Accordingly, Hedge Funds invest in distressed debt and purchase bonds of firms that have filed for bankruptcy. These bonds are purchased at a steep discount and if the company/ government begins to turn its fortunes around, then correspondingly, the value of the bond increases. Trafalgar Asset Managers, founded by Lee Robinson, has already launched a fund to invest in the debt of emerging economies.

Moving away from bonds, some fund managers have also seen the possible opportunities within emerging equity markets. Within the emerging economies, equities are trading at below-average valuations and therefore, this undervaluation is very attractive to both domestic and foreign investors.

However, with the possibility of high profits, also comes the possibility of high risk. For example, Argentinian government bonds have already fallen in price after the restructuring which only occurred over a month ago. Furthermore, the US election adds even higher risk and will affect the decision making of investors. If Joe Biden wins, then it is likely that there will be fiscal austerity (higher taxes), additionally, there will be less aggressive protectionist policies especially against NATO allies in Europe. Both of these will cause the dollar to weaken and therefore, should benefit emerging markets as it provides them more freedom to provide fiscal stimulus without fearing negative implications on their own economies.

In contrast, if there is a drawn-out, disputed election, investors will move out of these riskier assets that we see in emerging economies and into the dollar which will negatively impact Emerging Markets.

Conversely, Hedge Funds may instead follow the strategy of convertible arbitrage which UBS’ hedge fund unit has tripled their exposure too since March. Convertible arbitrage is a strategy by which hedge funds take a long position on convertible security (usually a bond) and a short position in the underlying common stock. Accordingly, the goal is to capitalise on the price inefficiencies between the convertible and the stock. This strategy has been delivering healthy returns to fund managers, however, it can be dangerous as the 2008 Financial Crisis highlighted where hedge funds lost 33.7% in the market’s chaos.

This alternative strategy of debt restructuring and investing in equities in emerging markets will be dependent on the level of risk an investor is willing to take. The outcome of the US presidential election will likely be a pivotal moment for the markets where no doubt Hedge Funds can make enhanced returns providing they call it right!