The economic growth of emerging markets, driven by a burgeoning middle class and increasing urbanization, provides an attractive investment opportunity for hedge funds. However, investors must also be prepared to stomach the increased volatility that often accompanies the promise of greater returns.
Preqin’s Hedge Fund Analyst currently tracks the performance of more than 400 funds targeting the emerging market space. As highlighted in the Preqin Quarterly Update: Hedge Funds, Q1 2014, funds with an emerging market focus have lagged behind those focused on developed markets in Q1 of 2014, recording -0.45% versus 2.33%. This trend is repeated over 12-month (+3.43% vs +11.07%) and three-year (+3.94% vs +8.36% annualized) periods. Risk-adjusted performance for those funds focused on emerging markets was also notably inferior over the last three years, with a Sharpe ratio of 0.29 versus 1.73 for developed market funds.
Recent events in Ukraine highlight the risk associated with political instability in emerging regions. Preqin’s Russia & Eastern Europe benchmark shows that funds in this region were down -9.29% in the first three months of 2014. Indeed, the region has presented a challenging investment environment for several years now, with funds posting an annualized loss of 8.96% over the last three years. Preqin’s Russia & Eastern Europe benchmark has been in drawdown since April 2011, reaching its lowest point in March 2014 of -24.56%. A negative Sharpe ratio over the last three years contrasts with one of 0.79 for the hedge fund asset class as a whole.
This theme of increased risk accompanied by smaller long-term returns is repeated across other emerging market regions over recent years. Asia-based emerging market funds have returned 3.06% and Latin America-based funds have gained 4.50% on a three-year annualized basis, with a Sharpe ratio of 0.09 (Asia) and 0.48 (Latin America).
However, just as Russia’s tumbling MICEX Index has proved testing to navigate for hedge funds, fund managers have found value in South Africa’s steadily rising FTSE/JSE All-Share index. Preqin’s Africa-focused emerging markets benchmark, largely comprised of South Africa-based private equity funds, recorded a positive return in the first quarter (+1.13%), continuing a consistent 12-month (+12.76%) and three-year (+12.93% annualized) performance. These returns were achieved without the additional risk expected of emerging market-focused funds, with a Sharpe ratio over three years of 2.90.
Despite the variation in return across the emerging markets spectrum, it should be noted that emerging market hedge funds have, on average, outperformed emerging market equities across all regions over the last three years. With equities often appearing undervalued in comparison to those in developed markets, as well as the diversification benefits they may bring to a portfolio, hedge funds focused on emerging markets continue to offer an intriguing opportunity to investors looking to tap into these developing regions.