Investment Focus

Emerging Markets Hedge Funds:

Capturing Alpha in an Inefficient Asset Class
Over the last twenty years, what was previously known as the developing world has undergone significant and
dynamic changes. In the capital markets, this group of countries is defined as every nation in the world excluding the
United States, Japan, the euro zone1, Australia, and New Zealand2 and is commonly referred to as the emerging
markets (EM). Today, EM represents a growing proportion of total global capital market securities. The breadth, depth,
and complexity of the EM opportunity set are well-suited to the unique skill sets of a group of asset managers known
as hedge funds. This paper posits that EM can be a source of opportunity for those hedge fund managers with
the specialized skills, experience, and local knowledge to exploit it. In doing so, hedge funds, particularly in a portfolio
context such as a fund of hedge funds, can generate attractive return profiles for investors who are willing to make EM
allocations in this manner.

The Emerging Markets Landscape

Historically, the term, emerging markets, was used to describe a
limited set of investments in immature domestic capital markets.
The dominant risk factor was the government, typically expressed
through a sovereign credit rating that was below investment grade.
In these countries, equity markets were characterized by high concentration and low liquidity. While this is an accurate description of
many countries that are now known as the frontier subset of EM,
it is interesting to note that many features of the core EM countries
(e.g., Taiwan, Korea, or Mexico) are currently on par with countries
that have historically been categorized as developed (e.g., Spain,
Portugal, or Ireland).
The evolution and growth of EM over the last quarter century is striking. At a high level, we can observe that the total market capitalization
of the countries included in the MSCI Emerging Markets Index grew
from approximately US$85 billion in 1990 to US$3.8 trillion as of
April 2014.3 This represents an increase in market size of greater than
forty times (i.e., more than 4,000%) over that time frame.
Drilling down further, we can also examine the evolution of the constituents of the MSCI EM Index. In Exhibit 1, we show the indexs
main constituents and their respective weights every five years from
1988 to 1998 with 2013 as a final reference. The changes in weightings over this period are remarkable.
Several noteworthy changes can be traced to specific events. For
example, from 1988 to 1993, Mexico increased from 10% of the
index to 21% while Brazil decreased from 25% to 11%, following the
privatization of Telefonos de Mexico in 1990, which created one of
the largest and most liquid EM equities. However, Mexicos weight
in the index fell to 11% in 1998 after the Mexican peso devaluation. During the ASEAN currency and debt crisis of 1997, Malaysia
instituted capital controls, causing it to be dropped from the index in
1998 (from 26% in 1993). In a similar vein, the combined weights of
Malaysia, Thailand, Indonesia, and the Philippines fell from 48% in
1993, before the crisis, to less than 7% in 1998.
Other changes to weightings have been more gradual, resulting from
country-specific effects and improved foreign investor access. For
example, Chinas participation in the index increased from 1% in
1998 to 20% in 2013 and was largely a function of its spectacular
economic growth as well as improved access to its growing capital
market by external investors through the introduction of the qualified
foreign institutional investor (QFII) program.4 While Chinas weight
in the index has increased, Brazils 25% share of the index in 1988
fell to 12% in 1998. This decline was not due to a shrinking Brazilian
market but resulted from the inclusion of Indonesia, Russia, Poland,
Venezuela, and other countries in the index.

Exhibit 1
Composition of MSCI EM Index (19882013)
1988 (%)

1993 (%)

1998 (%)

2.4

5.8

4.6

Brazil

25.5

11.0

11.9

10.7

Chile

7.8

5.5

4.5

1.6

China

0.7

19.8

Colombia

0.8

1.0

Czech Republic

1.1

0.2

Argentina

2013 (%)

Egypt

0.2

Greece

3.8

1.4

7.3

0.5

Hungary

1.6

0.3

India

7.9

6.3

Indonesia

5.6

1.8

2.2

Israel

3.3

Jordan

1.7

0.2

0.2

Korea

10.7

16.1

3.5

Malaysia

29.5

26.0

3.9

Mexico

10.0

20.7

11.3

5.4

Morocco

Pakistan

0.4

Peru

1.0

0.4

Philippines

3.0

2.9

2.1

0.9

Poland

1.4

1.7

Portugal

6.5

1.3

Russia

1.3

6.1

South Africa

10.3

7.4

Sri Lanka

0.1

Taiwan

9.9

11.7

Thailand

9.9

13.3

2.8

2.1

Turkey

2.8

2.0

1.5

Venezuela

1.0

As of December 2013
Source: MSCI

Economic development and changes to EM equity index constituents

have also been accompanied by credit rating agency upgrades for many
EM sovereign issuers. While the changes in Moodys sovereign credit
ratings for a number of EM countries since 1990 are not uniformly
positive, there is consistency between economic development, capital
market developmentboth in terms of market capitalization and
liquidityand assessment of sovereign risk (Exhibit 2).

Exhibit 2
EM Sovereign Credit Ratings Reflect Economic Consistency
BRIC
Aa2

Other EM
Aa2

A3

A3

Ba1

Ba1

B2

B2

Caa3

Caa3
China

1990

1994

India
1998

Brazil
2002

Mexico
Thailand

Russia
2006

2010

2014

1990

1994

Philippines
Argentina
1998

South Africa
2002

2006

2010

2014

As of 31 March 2014
Reflects each countrys Moodys foreign currency long-term rating at month-end.
Source: Countryeconomy.com

Emerging Markets Investing

In 1990, the emerging world was just beginning an accelerated
restructuring of the remnants of defaulted sovereign liabilities. These
debts had been the result of a lending binge by global banks that were
flush with the petro-dollars, which accompanied the oil crisis-driven
period of inflation in the 1970s. Sky-rocketing interest rates at the end
of that decade caused debt service burdens to rise dramatically, and
when the United States and much of the global economy went into
recession during the early 1980s, virtually all of the heavily indebted,
less-developed countries defaulted on their bank loans.
The defaulted loans were primarily traded by large banks such as
Bankers Trust, J.P. Morgan, Chase Manhattan, and Citibank, that
set up trading operations to facilitate exposure reduction and management by smaller banks, non-US banks, and larger companies that were
looking to shift exposure from a particular country where it no longer
had a presence to a country where it still had business operations.
In the latter part of the 1980s, several countries began privatizing
some of their large state-owned enterprises (SOEs) and allowed the
use of the defaulted loans in debt for equity transactions. During
this period, significantly lower interest rates allowed larger banks to
increase their provisions against their defaulted loan books, creating a
commercial incentive to sell or restructure these exposures. As a result,
debt trading volumes rose.
Improved economic conditions also prompted countries to explore
restructuring their liabilities. In 1989, Mexico was the first country to
use the Brady Plan model5 to restructure their defaulted bank debt
into more liquid tradable securities. More countries followed Mexicos
model and entered into similar restructurings. As the asset class grew
in liquidity and trading volumes, investment banks also participated,
eventually competing for underwriting and placement business for
newly issued sovereign bonds. In the second half of the 1990s, there
was also a growing traditional equity presence in EM.
As we mentioned, EM equity market capitalization was relatively small
in 1990, approximately US$85.5 billion versus US$5.1 trillion for
developed markets (DM), but has grown substantially since. Over the
period, EM equity market capitalization grew from less than 2% of the

developed world (as measured by the percentage of MSCI EM Index

constituents in the MSCI All Country World Index) to greater than
11% at its peak prior to the 2008 global financial crisis.6
EM debt markets underwent the same trajectory, as the market
capitalization of the bond indices that represent hard currency (J.P.
Morgan EMBI) and local currency (J.P. Morgan GBI-EM) EM debt
has grown significantly (Exhibit 3).

Exhibit 3
Growth of EM Bond MarketsMarket Capitalization
(US$ Billions)
1200
J.P. Morgan EMBI Global
J.P. Morgan GBI-EM Global Div
900

600

300

0
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

2014

As of 30 April 2014
Source: J.P. Morgan

Part of this dynamic was due to economic growth, but another part
resulted from the participation of global investors in EM capital
markets development. As demand for access by DM investors grew,
companies and their developed world investment banks responded
by creating depositary receipts (in the US, typically referred to as
American Depositary Receipts or ADRs)7 for investors to purchase.
The number of EM companies that were listed to trade on DM
exchanges and the volumes of these issues traded experienced tremendous growth. Since the 1990s the number of EM companies issuing
depositary receipts grew from approximately 1,500 to almost 4,000

in 2013.8 Accordingly, depositary receipt trading volume, which

was insignificant in the early 1990s, has grown to a total of roughly
US$120 billion in 2011 (Exhibit 4).
Assets in mutual funds dedicated to both EM debt and EM equity
strategies have also expanded dramaticallyparticularly those focusing on equities. More recently, several EM-focused exchange-traded
funds (ETFs) have been successfully launched, and the assets in these
vehicles have increased considerably, up roughly five-fold despite a
29% reduction from the January 2013 peak (Exhibit 5).

Exhibit 4
Depositary Receipts Total Trading Volumes
(US$ Billions)
120
Latin America
Africa

100

Eastern Europe
Asia Emerging

Thanks partly to this increased access to EM securities for global

investors, which also reflects substantial increases in domestic capital
markets, total EM equity trading volumes grew much more rapidly,
expanding six-fold since 2000, compared to those for DM which
increased roughly 40% over the same period (Exhibit 6).
Anecdotally, the evolution of the frontier markets9 is showing a
similar pattern: a growing number of participating countries, rising
market capitalizations, and increased number of listings and trading volumes. However, the data are still equivocal since MSCI only
launched its frontier markets indices in 2007 and due to the potential
for countries to change classifications between the MSCI EM Index
and the MSCI Frontier Index (Exhibit 7). For example, Argentina
was reclassified from EM to Frontier after its 2002 default and, more
recently, the United Arab Emirates and Qatar were both reclassified as
EM from Frontier.

Asia Developed

80

Exhibit 6
EMs versus DMsChange in EM Equities Average Daily
Trading Volume

60
40

(%)
600
2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1991

1992

20

As of 30 April 2014
Source: Citibank

Developed Markets

Emerging Markets

450
300
150

Exhibit 5
Asset Growth of EM Equity and Debt Mutual Funds

0
Developed Europe
Markets

(US$ Billions)
1,800
EM Equity

US

Other

Emerging Asia
Markets

EMEA LatAM

For the period 2000 to 2010

Source: World Federation of Exchanges

EM Debt

1,200

Exhibit 7
Growth of Frontier MarketsMarket Capitalization and ETF
Assets

600

0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

(US$ Billions)
200

MSCI Frontier Markets Index [LHS]

iShares MSCI Frontier 100 ETF [RHS]

Asset Growth of EM ETFs

(US$ Millions)
600

150

(US$ Billions)

400

200
100

150

200
50

100
50
0
2006

0
2007
2007

2008

2009

2010

2011

2012

2013

2014

As of 30 April 2014 for mutual fund data and 28 February 2014 for ETF data
EM Equity and EM Debt above represent Morningstars US OE Diversified Emerging
Markets and US OE Emerging Markets Bond categories, respectively.
Source: Morningstar, Investment Company Institute, Haver Analytics

0
2008

2009

2010

2011

2012

2013

As of 30 April 2013
The iShares MSCI Frontier 100 ETF was launched on 12 September 2012. The MSCI Frontier
Markets Index was launched on 18 December 2007.
The indices listed above are unmanaged and have no fees. It is not possible to invest directly in
an index. This is not intended to represent any product or strategy managed by Lazard.
Source: MSCI, BlackRock

We currently observe a notable decoupling in the growth trajectory for

EM and DM. In particular, the United States appears to be embarking
on further expansion while many EM countries are struggling with a
toxic combination of disappointing growth and high inflation. This is
likely the result of both the liquidity flood of global capital created by
unorthodox monetary policies in many developed nations, as well as
the inevitable scaling back of these policies. However, country-specific
issues, particularly in Brazil, Russia, India, and China (BRICs), are
also quite important.
In the case of China, rapid expansion during most of the 20002010
decade has led to a need to rebalance its economy away from investment and toward consumption, while simultaneously engineering
a slowdown in credit and economic growth without instigating a
banking crisis. To many, this would appear like a tall order. However,
even with a pessimistic forecast of 6% or 6.5% growth in real
GDP (versus the Chinese governments forecast of 7.5%), China,
as the second-largest economy in the world, will add more to global
growth in 2014 than any other single country except the United
States, and likely more than most of the OECD, ex-the United States
and Japan, combined.

Exhibit 8
Evolution of World GDP Composition
Share of World GDP (%)
100
75
50
25
0

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013E
2014E
2015E
2016E
2017E
2018E

Emerging Markets Today

Emerging and Developing Economies

Advanced Economies

As of 30 April 2014
Data are based on the IMFs country classification of advanced economies and emerging and developing economies. Estimated or forecasted data are not a promise or
guarantee of future results and are subject to change.
Source: IMF

Despite the current, potentially short-term decoupling, it is very likely

that EM will continue to experience faster secular economic growth
than DM for the foreseeable future. This is a trend that has existed for
some time, despite the many local and regional defaults, crises, and
geopolitical hiccups experienced over the last 25 years (Exhibit 8).

Exhibit 9
Historical P/E and ROE for World, EM, and Frontier Markets

While this secular opportunity implies potentially higher returns and

earnings growth for EM companies, the greater tendency for crisis
keeps the pricing of EM securities very attractive relative to DM.
Exhibit 9 shows the combination of lower price-to-earnings ratio
(P/E) with higher return on equity (ROE) that is a major attraction
for EM equity investments.

20

Emerging Markets Hedge Funds

Hedge fund investing in EM originated with large global macro funds
that directed some capital to trading external debt and currencies, a
logical development given that the talent and experience with EM in
the financial communityprimarily at the large global investment
bankshad been focused in these areas.
Starting in the 19952000 period, EM-dedicated hedge funds began to
emerge. Many of these efforts still evidenced strategies with a macro
or top-down orientation, choosing to maintain the freedom to invest in
debt, currencies, or other assets but also beginning to include equities in
the mix. Additionally, during this period, there were a small number of
firms that began emphasizing a bottom-up focus on stock picking and
a strategy of managing a more typical long/short hedge fund portfolio
of EM stocks. In many cases, the founders and portfolio managers of
these firms came from institutional asset managers such as Morgan
Stanley and J.P. Morgan, as well as large macro funds including Tiger
Management and Tudor Investment Corporation.

P/E
30

10

2008

2009

2010

2011

2012

2013

2014

2009

2010

2011

2012

2013

2014

ROE (%)
20

15

10

2008
EM

World

FM

As of 30 April 2014
Past performance is not a reliable indicator of future results. Data are based on the
MSCI EM, MSCI Frontier Markets, and MSCI World indices.
Source: MSCI

During the global financial crisis, similar to the pattern of mainstream

hedge funds, EM hedge fund performance was disturbingly negative,
although some managers were able to protect capital relative to the
53.5% decline of the MSCI EM Index for 2008. However, the
recovery in 2009 was also quite strong, and since then, assets in EM
hedge funds have grown substantially: from roughly US$2.5 billion in
2000 to approximately US$150 billion today.10

For example, event-driven managers can typically select any instrument in the capital structure of a company to express their view,
whether it is stocks, bonds, bank debt, or hybrid securities like preferred equity or convertible bonds. This view is typically a call on the
outcome of a particular event that a company is undergoing, such as
a restructuring or a takeover. This flexibility is not typically found in
traditional fixed income and equity investment products.

Based on data from multiple hedge fund databases (aggregated by

PerTrac, as of April 2014), the category with the most EM-focused
funds is long/short equity, followed by relative value and event driven.
By total assets, the same categories top the list, but global macro
strategies also have meaningful assets under management despite
having fewer hedge funds in this category. According to Hedge Fund
Research, out of a universe of 1,145 EM hedge funds as of the end of
the fourth quarter of 2013, 30% percent have assets exceeding US$50
million, and 57% of the total have a track record greater than five years.

Global macro managers can have long or short positions across a vast
number of different securities, from currency forwards to equity or
bond futures, or from interest rate or credit default swaps to cash
instruments. Even a large-cap, US long/short equity manager has
the flexibility to adjust gross exposures significantly, increasing or
decreasing economic and/or market risk to suit his or her view.11
The less developed nature of emerging and frontier markets means
that the linkages between equity markets, currency markets, and credit
markets are potentially more impactful than in the developed world.
The emerging opportunity set is also spread across regions with distinct economic, political, and market environments (i.e., Asia, Latin
America, Africa, Eastern Europe, and the Middle East).

The arrival of hedge funds dedicated to frontier markets is a more

recent phenomenon. Given the rapid bounce in the BRIC markets
post-2008, investors began to look farther afield for the characteristics
that were reminiscent of the earlier days of EM investing, such as
single digit P/E ratios with earnings growth in the territory of 18%
to 25% per annum. Frontier markets such as Bangladesh, Vietnam,
Nigeria, and Kenya offered companies with these characteristics, but
these markets were also smaller with liquidity constraints that have
kept investor participation to a small number of specialized managers
with limited assets.

Additionally, there are often dramatic differences between individual

countries within a given region. For instance, the recent crisis in
Ukraine has had a large, direct impact on Russia but is affecting
Turkey very little relative to domestic Turkish politics, even though
both countries are considered part of the eastern European EM region.
This situation is analogous to Mexico and Brazil in Latin America or
Thailand and Indonesia in Southeast Asia. The distinct characteristics
of individual EM countries create even more opportunity for alpha
generation with unconstrained investment strategies than in DM.

Alpha Generation
Generally speaking, the source of alpha for all hedge funds is the skill
of the managers deploying their strategy. However, also important in
their ability to leverage their skill sets is the unconstrained nature of
their investment approach.

Stock Picking
Historically, EM hedge funds have been an excellent source of
stock picking alpha, and we expect that this trend is likely to
continue. While EM hedge fund managers are intelligent, dynamic,

Exhibit 10
EMs Offer Wider Return Dispersion
Return (%)

Developed Markets

Emerging Markets

300
Annualized Return

Range

200

100
7.94

11.02

MSCI World
Index

Australia

-100

0.79

Japan

8.47

10.63

United
Kingdom

United
States

12.12

17.07

10.59

19.99

8.24

MSCI EM
Index

Brazil

Indonesia

Mexico

Philippines

For the period 1988 to 2013

Past performance is not a reliable indicator of future results. The indices listed above are unmanaged and have no fees. It is not possible to invest directly in an index. This is not intended to
represent any product or strategy managed by Lazard.
Source: Bloomberg, MSCI

and successful market participants, this does not particularly distinguish them from DM hedge fund managers. We suspect that EM
hedge fund managers also enjoy a differentiated opportunity set compared to their DM peers.
To test this theory, we look at the compound annual return in the
context of the range of annual performance of the MSCI EM Index
and several of its individual constituents compared to the MSCI
World Index and several of its constituents over the period from
1998 to 2013. Exhibit 10 clearly shows an increased dispersion in
returns available to EM investors. For example, while Australia and
Indonesia had very similar compound annual returns over the period,
Indonesias worst year was -74% versus -49% for Australia, with bestyear numbers being +258% versus +77%.

Shorting
In all hedge fund strategies, shorting adds to alpha in two ways:
1) offsetting some of the market risk of the long portfolio and
2) generating gains from security-specific risk in the short portfolio.
In the latter case, these can either be outright profits or relative gains
when short positions go down more (or up less) than either the market
or the long portfolio or both.
In general, shorting is more challenging in EM, due to a more fractious regulatory environmentwith many instances of shorting being
illegal or prohibited by regulations12 as well as a less-developed securities lending business in many individual markets.13 However, there
has been progress in the ability to short in EM in recent years.
In some markets, while shorting cash equities is not permitted, there is
an active futures market, which allows market hedging and facilitates
intermediaries to offer short exposure via derivatives. This is the case
in Brazil, Taiwan, and Korea. In China, the domestic market is protected, and shorting is not permitted. However, in addition to being
listed on local exchanges in mainland China, many Chinese companies are also listed in Hong Kong, where there are no restrictions on
foreign investments and where shorting is permitted. In addition,
many EM hedge funds take advantage of other markets to implement
short hedges, as we discuss in detail below.

Credit, Interest Rates, and Derivatives

As we mentioned earlier, publicly traded EM fixed income was more
or less unknown prior to the Brady Bond exchanges of the late 1980s
and early 1990s, which converted defaulted bank debt into marketable
sovereign securities and restored access to the new issue markets, helping many EM countries to refinance impaired multi-lateral debt. Since
then, there has only been one event of default on an EM external
bond issued in hard currency.14
During this same period, investors also began to look at local money
market products. Despite enduring the Mexican Tequila crisis in
19941995, the Asian debt crisis in 1997, the Russian crisis in 1998,
and the Brazilian currency crisis in 2002 along with a series of rolling
disasters in Argentina throughout this period, investors extended their
appetite to local currency bonds of longer duration. We illustrated the
evolution of these markets earlier in Exhibit 1.

Parallel with the growth in both the external and local credit markets
for EM has been the growth in derivatives associated with these
securities. Credit default swaps (CDS), have proliferated in EM.15
For example, the Markit EM CDX, an index of sovereign default
protection covering EM external credit broadly, is now a very liquid
instrument, trading on the order of over US$ 500 million daily.16
Individual sovereign CDS also trade with reasonable liquidity for
countries with moderate amounts of outstanding external debt, such
as Russia and Turkey. Also, the development of local currency money
markets and bond markets has generated a vibrant market for interest
rate swaps in the larger EM countries.
The breadth of these EM markets gives managers with the appropriate expertise a large number of ways to express a view on a particular
country or market and to hedge or add exposure. Managers can be
long or short external credit risk, taking a view not only on default
but also on risk premium or spread. They can also be long or short
local currencies.
Any of the positions described above can be used either as a hedge to
existing exposures or as an outright position. For example, if a manager sees value in the prices of industrial company equities in Brazil
but is worried about overall economic growth, they can hedge their
macro risk by entering into a receiver swap, which will profit if growth
disappoints and domestic rates fall, or by shorting the local currency,
which might weaken if the local economy falters.
While it tends to be the macro and relative value players who are most
active in the credit, rates, and currency markets, equity long/short
managers can also benefit from the ability to hedge currency or interest rate risk. In certain situations the debt of state-owned companies
in an emerging country where there are significant macro headwinds
(e.g., Venezuela or Russia), can offer an equity-like return to investors with a flexible mandate.
Regardless of strategy, the existence of these markets creates tremendous opportunities for additional alpha to be generated by EM hedge
fund managers.

Hedge Fund Performance

Hedge Fund Research, a leading hedge fund industry data aggregator, has generated an EM hedge fund index (HFRI EM). Looking at
the graph in Exhibit 11 (which shows performance from May 2005
through May 2014), a couple of observations are clear: 1) EM hedge
funds, as a group, tend to underperform in strong EM market environments and outperform in weak EM market environments; 2) EM
hedge funds have a total volatility that is considerably lower than the
MSCI EM Index.
This pattern of performance suggests significant alpha generation,
particularly when looking at returns in the context of risk. Exhibit 12
plots the total annualized return versus annualized volatility (using
monthly data from January 1994 to December 2013) of the HFRI
EM and the MSCI EM indices versus several other market benchmarks so that we can observe the characteristics of this performance
stream in a broader context. Note the tendency for the EM hedge
fund index to be up and to the left relative to the equity return of
the MSCI EM Index.17

Exhibit 11
Historical Performance of HFRI Emerging Markets Index and
MSCI Emerging Markets Index
Return (%)
30
MSCI EM Index

Exhibit 12
Favorable Pattern of Returns for EM Hedge Funds
Annualized Return (%)
15

HFRI EM (Total) Index

15

J.P. Morgan EMBIG

10

S&P 500 Total Return Index

HFRI EM (Total) Index

Barclays Capital US Aggregate Bond Index

5
-15

MSCI EM Index
0

-30
2005 2006

0
2007

2008

2009

2010

2011

2012

2013

10

15

2014

20
25
Annualized Volatility (%)

As of 31 May 2014

For the period 1 January 1994 to 31 December 2013

The indices listed above are unmanaged and have no fees. It is not possible to invest
directly in an index. Past performance is not a reliable indicator of future results. This is
not intended to represent any product or strategy managed by Lazard.

The indices listed above are unmanaged and have no fees. It is not possible to invest
directly in an index. Past performance is not a reliable indicator of future results. This is
not intended to represent any product or strategy managed by Lazard.

Source: MSCI and HFR

Source: Bloomberg

EM Hedge Fund Investing

The track record of EM hedge funds, though limited relative to that
of DM hedge funds and DM benchmarks, is exactly what we would
expect to see given the rich alpha opportunities generated by the
confluence of EM dynamics and hedge fund investment philosophies.
While past performance is never indicative of future results, it is clear
that, at a minimum, the alpha wind is at an allocators back when considering exposure to EM via hedge funds.
Hedge funds have become significantly more transparent and communicative with their clients and prospective investors in the last 1520
years. EM hedge funds are no exception and, if anything, are likely to
be more transparent about exposures and processes, recognizing that
investors are undertaking greater risk just being in the asset class and
not wanting to compound that with greater manager risk.
However, as opportunities have expanded, the plethora of countries,
regions, asset classes, and investing strategies, combined with the typical lack of public information about hedge funds, makes the job of
selecting an EM hedge fund a challenge.
We would argue that a portfolio approach makes the most sense when
considering an allocation to EM hedge funds. In comparison to a
direct investment in an individual EM hedge fund manager, an allocation to a portfolio of emerging- and frontier-focused hedge funds can
provide investors many potential benefits, including diversification,
less correlated or uncorrelated returns within underlying strategies,
and access to smaller or niche managers with capacity constraints.
From a diversification perspective, an EM hedge funds portfolio
enables investors to gain exposure to a variety of strategies, which
focus on different EM geographies and invest across different asset
classes. This type of diversification not only inherently reduces single
manager risk (i.e., risk of putting all your eggs in one basket) but
can also help dampen an investors exposure to EM political risk and

volatility of EM capital markets. Furthermore, besides market and

investment-related risks, allocators should also consider the possibility
of heightened operational risks associated with clearing, settlement,
and custody when investing in individual EM hedge funds since
operational, accounting, and regulatory standards in EM may not be
as rigorous as those in DM. These risks are particularly relevant for
frontier strategies.
Additionally, this diversification of assets, strategies, regions, and
investment risks has a powerful effect on the volatility of portfolio
returns. The predicted performance pattern, proven through the
experience of EM funds of funds, is for a portfolio of EM hedge funds
to significantly protect capital during sharp EM sell-offs, while participating ineven if not always matchingupside benchmark moves.
These performance characteristics make a portfolio of EM hedge funds
an excellent choice in multiple contexts: a) first-time exposure for an
investor wary of EM volatility, b) a core global EM allocation to which
opportunistic satellites are added, such as high beta exposure to a
particular country or region with higher expected returns, c) a complimentary addition to established EM exposure which adds alternative
sources of return (alpha) while not adding to, and even potentially
lowering, total portfolio risk.
However, to source a diversified portfolio that can take advantage of
the potential benefits offered by emerging and frontier market hedge
fund strategies, investors will need to have a specialized network to
source managers with appropriate EM experience and skill. They also
need enough familiarity with EM market dynamicsknowledge typically gained only from direct experienceto be able to competently
evaluate a given managers investment and operational processes.
Furthermore, investors need dedicated resources to maintain ongoing
due diligence activities on a rather geographically diverse opportunity
set. Even more for EM than for DM, the outsourcing of this task to a
specialist in EM hedge funds may be advisable.

Conclusion
As Exhibit 10 shows, EM investments have historically been much
more volatile than DM. For investors with the risk tolerance to
be fully exposed to EM market risk, good total returns should
accompany the improving EM fundamental growth story. However,
investors willing to make this choice should expect large potential
drawdowns and an increase in total portfolio risk to accompany
these potential returns. Care might have to be taken in timing an
investors entry into the market, given the impact of capital flows,
the variability in valuations and the price volatility that EM securities
so frequently experience.
Few investors can credibly claim to have this timing skill, and many
readily admit that they do not. Some investors might be unwilling to
consume a large proportion of their total portfolio risk budget with an
EM allocation. Others might seek a better risk-reward outcome for, or
as a complement to, their core EM allocation. For all of these investors, EM hedge funds are a sensible idea worthy of consideration, and
an EM fund of hedge funds with global coverage of the opportunity
set, dedicated portfolio management resources, and specialized experience and skill, may be an efficient implementation of the idea.

About the Team

Lazards Fund of Hedge Funds investment team is led by Kit Boyatt,
Christian Frei, and Chris Heasman and has over 70 years of combined
experience investing in emerging markets (EM). With 31 years of
hedge fund investment experience on average, the lead portfolio
managers each have had direct EM capital markets experience or have
previously managed EM investment strategies. Currently, the team
manages over US$600 million in institutional assets that are invested
with EM-dedicated managers and has the unique ability to leverage
Lazards deep EM-focused research pool when validating the skill set
of managers and evaluating the quality of underlying hedge fund portfolios.

10

Appendix 1
Country Classifications
Frontier Markets in MSCI Classification

Emerging Markets in MSCI Classification

Americas

Europe & CIS

Africa

Middle East

Asia

Americas

Argentina

Bosnia
Herzegovinaa

Botswanaa

Bahrain

Bangladesh

Brazil

Bulgaria

Ghanaa

Jordan

Pakistan

Chile

Kenya

Kuwait

Sri Lanka

Colombia

Mauritius

Lebanon

Vietnam

Peru

Morocco

Oman

Nigeria

Palestinea

Tunisia

Saudi Arabiab

Jamaicaa
Trinidad &
Tobagoa

Croatia
Estonia
Lithuania
Kazakhstan
Romania
Serbia

Mexico

Zimbabwea

Europe, Middle
East and Africa

Asia

Czech
Republic

China

Egypt

Indonesia

Greece
Hungary
Poland
Qatar
Russia
South Africa

Slovenia

Turkey

Ukraine

United Arab
Emirates

India
Korea
Malaysia
Philippines
Taiwan
Thailand

As of 10 June 2014
a The MSCI Bosnia Herzegovina Index, the MSCI Botswana Index, the MSCI Ghana Index, the MSCI Jamaica Index, the MSCI Trinidad & Tobago Index, the MSCI Zimbabwe Index, and the
MSCI Palestine IMI are currently stand-alone country indices and are not included in the MSCI Frontier Markets Index. The addition of these country indices to the MSCI Frontier Markets
Index is under consideration.
b The MSCI Saudi Arabia Index is currently not included in the MSCI Frontier Markets Index but is part of the MSCI Gulf Cooperation Council (GCC) Countries Index.
IMF country classifications can be found in the following link: http://www.imf.org/external/pubs/ft/weo/2014/01/pdf/statapp.pdf
Source: MSCI, IMF

Notes
1 Excludes certain countries in the euro zone periphery that have recently joined the ranks of EM, namely Greece and Cyprus.
2 There are many inconsistent definitions (e.g., the countries in the MSCI Emerging Markets Index are not the same as those on the list of countries that the IMF defines as emerging economies). For the purposes of this paper, we will use the definition as described and include Frontier Markets in the broad discussion. Refer to the Appendix 1 for a list of all EM countries and
those in the Frontier subset.
3 Source: MSCI
4 The QFII program was introduced in 2002 and allowed foreign investors access to Chinese stock exchanges in Shanghai and Shenzhen. Prior to the QFII program, foreign investors were prohibited from directly purchasing or selling stocks.
5 These restructurings, first articulated by US Treasury Secretary Nicholas F. Brady in March 1989, involved converting defaulted bank loans into longer-duration bonds with principal collateral
and some coupon protection in the form of US Treasuries. The basic idea was debt relief in exchange for a commitment of economic reform and an assurance of eventual payment. The ease
of transfer of these centrally clearable bonds increased liquidity and tradability, allowing risk to be diversified throughout the global financial community and eventually restoring these countries access to global capital markets. See The EMTA (Emerging Markets Traders Association) for more information. http://www.emta.org/
6 The post-crisis peak was slightly under 14%, but it has dropped back to the 10% range currently, given the strong relative performance of DM versus EM in the last several years.
7 ADRs (American Depositary Receipts) are negotiable certificates issued by a US bank, representing a specified number of shares in a foreign stock that is traded on a US exchange.
8 Source: BNY Mellon
9 Refer to Appendix 1 for a list of Frontier Market countries.
10 Source: Current data from HFR and Eurekahedge. 2000 data is an estimate from Lazard.
11 Gross exposure measures total economic risk and is defined as the gross long portfolio, expressed as a percentage of NAV, added to the gross short portfolio expressed in the same way. The
net exposure measures market risk and is defined as the gross long less the gross short portfolio. Most long/short managers vary their gross exposure between 75% and 200% of NAV and
their net exposure between 25% and 100% of NAV.
12 As of March 2014, Argentina, Brazil, Bulgaria, Chile, China (B shares), Colombia, Croatia, Cyprus, Egypt, Estonia, Greece, Iceland, India, Indonesia, Latvia, Lithuania, Malaysia, Morocco,
Pakistan, Peru, Philippines, Romania, Serbia, Slovak Republic, Slovenia, South Korea, Sri Lanka, Taiwan, Venezuela, and Vietnam are EM and Frontier countries that allow foreign investors to
invest in domestic cash equities but prohibit shorting via cash equities. Synthetic instruments such as equity swaps are used in some of these markets.
13 In order to sell a stock or other security short, the seller must borrow the security. This is accomplished through a securities lending transaction, typically facilitated by a broker/dealer. A summary is available from International Capital Market Association: http://www.bankofengland.co.uk/markets/Documents/gilts/sl_intro_green_9_10.pdf
14 This is Argentina in 2001. Technically, Russia was in default of its external obligations due to cross defaults with its domestic, ruble-denominated Treasury bills called GKOswhich the
country defaulted on in 1998. However, despite defaulting on GKOs, Russia never missed a coupon or principal payment on its external bonds.
15 CDS are contractual agreements where the purchaser receives protection from an event of default in a particular credit in exchange for a series of payments over a specified time frame. The
seller collects the payments in return for absorbing any economic loss in the event of default.
16 Source: Bloomberg
17 The capital markets line (CML) is the theoretical relationship between different investment opportunities in the capital markets with distinct risk and reward characteristics. It should typically
and over timebut does not always in practice or at given points in timerise with a positive slope from lower returns for cash and low-risk instruments on the left of the graph, to higher
returns from equities and other riskier investments on the right side of the graph.

11

Important Information
Published on 11 July 2014.
An investment in any alternative investment is speculative, involves a high degree of risk, and may lose value at an accelerated rate. Privately offered investment vehicles (hedge funds, which
includes funds of funds) are unregistered private investment funds or pools that invest and trade in many different markets, strategies, and instruments. Hedge funds generally are not subject
to regulatory restrictions or oversight. Opportunities for redemptions and transferability of interests in hedge funds are often restricted so investors may not have access to their capital if and
when it is needed. Typically, there is no secondary market for an investors interest in a hedge fund. The fees imposed on hedge fund investments, including management and incentive fees/
allocations and expenses, may offset trading profits. An investor should not invest in any hedge fund unless he or she is prepared to lose all or a substantial portion of his or her investment. These
and any other risks involved in an investment in any hedge fund should be considered carefully before an investment is made.
Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile,
and less subject to governmental supervision than in ones home market. The values of these securities may be affected by changes in currency rates, application of a countrys specific tax laws,
changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of
company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political,
social, and economic factors affecting companies in emerging-market countries.
Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data). However, MSCI has not reviewed this product or report, and does not endorse
or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express
or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.
This paper is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract
or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in
any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited.
Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place,
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