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2 Brazil’s Central Role In South America

2 Brazil’s Central Role In South America

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J. Barreiro and J. Longo


with an important export advantage relative to other countries in the

region. Furthermore, its South American roots give it an advantage

over North American, European, and Asian countries when selling goods

and services to countries in the Latin American region. A key takeaway

for hedge fund managers is, similar to China, Brazil has the capacity

to grow domestically and regionally, despite the global slowdown that

has engulfed much of the developed world in 2008.

The European Union (EU) and North American Free Trade

Agreement (NAFTA) are well known international trading blocs.

Several South American countries formed in 1991 a trade bloc called

Mercosur; whose English translation is the “Common Market of the

South.” Mercosur’s short-term goal is to eliminate barriers to trade

among member countries. Its’ long-term goal is complete South

American economic integration. Mercosur’s members account for 75%

of South American GDP and it is the fourth largest trading bloc in the

world behind the EU, NAFTA, and the Association of South East Asian

Nations (ASEAN).10

Brazil has sought to increase its power in South America and

throughout the rest of the world through a number of initiatives, in

addition to its primary role in Mercosur. Soares de Lima (2008) points

to the following recent moves that demonstrate Brazil’s increasingly

global ambitions:

Its active campaign to obtain a permanent seat on the UN

Security Council.

The formalization of relations among the BRIC countries.

Its formation of the ISBA (India, Brazil, and South Africa)


Its role in the creation of the Union of South American Nations


Its command of the UN peacekeeping mission in Haiti.

Its role in the creation of the G-20, which focuses on agriculturerelated issues in the WTO.

Its proposal to create a South American Defense Council as a

mechanism to prevent conflict in the region.

Achieving Hedge Fund Alpha in Brazil


4.3 Brazilian Investor Profile and Behavior

Brazilians’ wealth has been growing at a rapid pace. According to the

2008 edition of the annual Capgemini Merrill Lynch World Wealth

Report, the number of Brazilians with $1 million or more in liquid net

worth increased 19% over the prior year to 143,000. Clearly, the global

bear market of 2008 will reduce these numbers, but many viable, cash

flow positive businesses in Brazil have been created over the past

decade. These businesses will continue to generate wealth for their

owners. As noted previously, less than 500 stocks trade on the Brazilian

stock exchange, BM&FBOVESPA, so the magnitude of the decline in

privately held businesses is likely to be less precipitous.

A 2005 study by Instituto Brasileiro de Opinióo Pỳblica e Estatớstica

(IBOPE) and Associaỗóo Nacional dos Bancos de Investimento

(ANBID) discussed the profile of the typical Brazilian investor. The

typical Brazilian investor is an upper middle class to wealthy citizen

(usually male) in his late 50s, earning between $24,000 and $48,000 per

year. This income range is approximately 3 to 5 times that of the average

Brazilian citizen. These investors allocate the bulk of their investments to

mutual fund type vehicles with the overall goals of preserving capital,

earning a reasonable return, and having strong liquidity.

Brazilian investors place a high premium on liquidity due to their

long dated experiences with the ravages of inflation. Furthermore,

transparency for Brazilian firms is lacking relative to other firms around

the world. For example, Brazil has not yet implemented international

financial reporting standards (IFRS), in contrast to virtually all of

Europe, India, Russia, Singapore, Hong Kong, and many other countries.

The CVM has declared that listed Brazilian firms should comply with

IFRS by 2010 so the transparency issue is likely to improve over time.

Despite the transparency concerns, many investors are willing to take

the plunge into the Brazilian markets due to their long term secular

trends. International investors account for the largest share (37%) of

trading volume of Brazilian equities, according to BOVESPA’s Facts &

Figures (2008). These investors fall into two broad categories, long-term

and short-term. The long-term investors in general desire exposure

to the Brazilian financial markets and base their decisions to a large


J. Barreiro and J. Longo

extent on fundamentals and secular trends. Conversely, hedge funds

(Portuguese translation: fundos multimercado) domiciled in Brazil are

required by the Comissão de Valores Mobiliários (CVM), the regulatory

agency of Brazilian financial markets, to provide their investors with

daily liquidity. This constraint results in a strong preference for hedge

funds to engage in active trading strategies.

Fundos multimercado and other Brazilian money managers also have

a short term focus due to the manner in which they quote their returns. In

order to induce investors, mindful of the days of high inflation, portfolio

returns are quoted on the basis of CDI (Certificado de Deposito

Interbancario) a daily interbank rate, instead of the traditional total return

or net asset value approach.

De Medeiros (2005) finds that Brazilian investors overreact to

positive shocks or good news and underreact to negative shocks or bad

news. He cites “one possible explanation is that the Brazilian market is

small as measured by the number of securities listed, quantity of

investors, and market capitalization. Usually, such relatively small stock

exchanges are dominated by speculative investors who respond to longrun rather than short-run market fluctuations.”

5. Hedge Fund Strategies in Brazil

The unique dynamics of the Brazilian financial markets make some

hedge fund strategies more likely to outperform than others. Rather than

listing a specific trade, that would likely be obsolete by the time of

publication, our goal is to discuss hedge fund strategies that have the

increased likelihood of earning alpha for the decade ahead. Our

approach is to link Brazilian cultural issues and market microstructure to

common hedge fund strategies. In our view, the following strategies are

most likely to generate significant alpha for hedge funds trading in Brazil

in the decade ahead.

Achieving Hedge Fund Alpha in Brazil


5.1 Global Macro

The high levels of volatility of the Brazilian equity and fixed income

markets are well suited to the strategies of Global Macro hedge funds.

One estimate finds that 70%–75% of the hedge funds operating in Brazil

in 2006 were Global Macro hedge funds.11 BM&FBOVESPA operates

a sophisticated electronic system with ample liquidity for macro related

trades, such as equity indexes, fixed income indexes, and currency

related trades. Furthermore, the daily liquidity requirement of Brazilian

hedge funds places primary emphasis on entering and exiting positions

quickly. In short, Global Macro hedge funds have and will continue to

find fertile ground for generating alpha in Brazil.

5.2 Fixed Income / Credit

High nominal and real interest rates on Brazilian debt are enticing to both

Fixed Income hedge funds and traditional investors. Exchange rate

changes also add to or detract from returns. Figure 2 shows yields on

Brazilian Government Bonds as of mid-November, 2008. The nearly

unprecedented turmoil in the global credit markets has pushed annual

yields on 8-year Brazilian debt to almost 19%. Brazilian sovereign debt

is generally limited to maturity dates of eight years or less due to investor

weariness with the country’s historical bouts of high inflation. Corporate

bonds are relatively thinly traded in Brazil since their yields are generally

300 to 1000 basis points higher than sovereign debt. Accordingly,

traditional corporate bond issuance is extremely expensive and not a

common form of financing. Brazilian firms generally prefer bank debt

and equity for their external financing needs. Fixed income hedge funds

can employ typical arbitrage strategies on sovereign Brazilian debt and

derivatives. To a lesser extent, they can go long Brazilian corporates and

hedge with fixed income indexes or derivatives.

J. Barreiro and J. Longo


Figure 2: Yields On Brazilian Government Bonds, November 14, 2008

Note: The upper curve represents the current yield curve and the lower curve represents

the yield curve at the close of the prior day, October 23, 2008.

Source: Bloomberg

5.3 Event Driven

Hedge funds that focus on event driven strategies should find attractive

alpha opportunities in the Brazilian financial markets. The previously

cited work finding overreaction in the presence of good news and

underreaction to bad news provides a strong framework for alpha

generating strategies. Brazil’s expected adoption of IFRS by 2010 will

likely increase the opportunity for earnings based event studies. In

addition, the continued growth of and interest in the Brazilian financial

markets will surely result in more sell side research on Brazilian firms in

the decade ahead, creating alpha generating opportunities for event

strategies based on security upgrades, downgrades, and earnings estimate


Achieving Hedge Fund Alpha in Brazil


5.4 Statistical Arbitrage

The technological infrastructure of BM&FBOVESPA is quite advanced

and it is expected to continue to progress upward due to the reciprocal

ownership relationship with CME. Most trading is done electronically,

but an open outcry floor is still available for trading derivatives.

BM&FBOVESPA’s website states that 99.5% of orders sent to its Mega

Bolsa system take less than 0.62 seconds to be processed and that its

Global Trading System is capable of executing 250 transactions per

second. Hence, high frequency statistical arbitrage hedge funds should

find that their strategies are executed efficiently.

One advantage of the near monopolistic nature of BM&FBOVESPA

is that trading across asset classes and financial instruments is somewhat

seamless, relative to similar strategies conducted on foreign exchanges.

Strong technology in concert with high volatility creates fertile alpha

ground for Statistical Arbitrage hedge funds. The daily liquidity

requirement of Brazilian hedge funds, make Statistical Arbitrage a more

economically viable strategy than Distressed, Short Selling and other less

liquid strategies. The primary impediments to achieving alpha at this

time are the limited number of individual securities and relatively low

trading volume for securities outside the largest 50 to 100 names,

especially on the short selling side of the hedge fund book.

5.5 Multistrategy

Multistrategy funds can turn the relative illiquidity of the Brazilian

financial markets into an advantage, by telling their investors that they

can allocate capital towards the most promising areas of the market. A

Multistrategy fund that emphasizes the strategies discussed above —

Global Macro, Fixed Income / Credit, Event Driven, and Statistical

Arbitrage — is likely to generate the best results. Brazil’s primary role in

South America may enable Multistrategy funds to expand into related


J. Barreiro and J. Longo

markets, since each additional market is likely too small to accommodate

traditional hedge fund strategies. In other words, a South American

Multistrategy Fund, with a Brazilian focus may maximize alpha

opportunities and allow for reasonable capacity.

Achieving Hedge Fund Alpha in Brazil


Hedge Fund Alpha Tear Sheet — Chapter 3

The economies of Brazil Russia India and China (BRIC) are

expected to be near the top of world GDP charts by 2050.

Accordingly opportunities in Brazil and the rest of the BRIC

countries may make it a fertile source of alpha in the decades


Brazil’s economy, with 2007 GDP of approximately $1.5

trillion, is the second largest in the Americas, and among the ten

largest in the world.

o Brazil’s GDP is projected to rank the fourth largest in the

world by 2050.

The vast majority of Brazilian financial market trading activity is

conducted on BM&FBOVESPA, the third largest exchange in

the world by market capitalization.

Investors in Brazilian financial markets have dealt with many

bouts of high inflation and remain wary of its risks.

o This wariness is one reason for the daily liquidity

requirement forced upon hedge funds domiciled in Brazil.

Brazil’s prominent role in South America provides it with a

strong platform for growth, despite the global credit crisis of


Transparency in Brazilian financial markets is lacking, but is

expected to improve markedly by 2010 with the adoption of the

International Financial Reporting Standards (IFRS).

Empirical studies have found Brazilian investors overreact to

positive news and underreact to negative news.

o These persistent behaviors may form the basis for alpha

generating strategies.

In our view, the following hedge fund strategies in Brazil are

best poised to deliver alpha in the decade ahead.

o Global Macro

o Fixed Income / Credit

o Event Driven

o Statistical Arbitrage

o Multistrategy

J. Barreiro and J. Longo


End Notes


The 2050 GDP forecasts come from Wilson and Stupnytska (2007) of

Goldman Sachs.


Hargreaves (2008) discusses Brazil’s interest in joining OPEC.


The BM&FBOVESPA website provides various statistics on trading in

the Brazilian financial markets.

4, 5

Leal, Ricardo and Andre Carvalhal-da-Silva, “The Development of

the Brazilian Bond Market,” Working Paper, Federal University of Rio

de Janeiro (UFRJ), September 13, 2006.


Hugh (2008) cites the Brazilian national debt figures.

7, 8

These statistics are from Basar (2008).


The differences in Brazil’s 2007 GDP figures in Tables 2 and 3 may be

explained by the different sources (Goldman Sachs vs. CIA World

Factbook) and currency adjustments. Additionally, the Goldman Sachs

figure is actual, while the CIA Factbook number is estimated.


These statistics are from Klonsky and Hanson (2007).


WealthNet is the source of the estimate.


Amante, André, Araujo, Márcio, and Serge Jeanneau, “The Search for

Liquidity in the Brazilian Domestic Government Bond Market” BIS

Quarterly Review, June 2007, pp. 69–82.

Basar, Shanny, “Brazilian Exchange plans to take on the world”, Dow

Jones Financial News Online, June 23, 2008.


Achieving Hedge Fund Alpha in Brazil


BOVESPA’s Facts and Figures, June, 2008.


BOVESPA Homepage.


Capgemini Merrill Lynch World Wealth Report, 2008.

CIA World Factbook, GDP Purchasing Power Parity.



De Medeiros, Otavio R., Reaction of the Brazilian Stock Market to

Positive and Negative Shocks, December 5, 2005.


Economist.com, Country Briefings: Brazil.


Embassy of Brazil in London website.


Goldman Sachs, Market Profile, Brazil, June 22, 2007.

Hargreaves, Steve, “Brazil Dances with OPEC,” February 22, 2008.



Hugh, Edward, “Brazil Debt Raised To Investment Grade By Standard

and Poor’s,” Thursday, May 01, 2008.



DE FUNDOS NO BRASIL. Retrieved May 18, 2008, from IBOPE.




J. Barreiro and J. Longo

International Monetary Fund — Data and Statistics.


Klonsky, Joanna and Stephanie Hanson, “Mercosur: South America’s

Fractious Trade Bloc,” Council on Foreign Relations, December 7, 2007.


Leal, Ricardo and Andre Carvalhal-da-Silva, “The Development of the

Brazilian Bond Market,” Working Paper, Federal University of Rio de

Janeiro (UFRJ), September 13, 2006.

Soares de Lima, Maria Regina, “Brazil Rising”.


The WealthNET, “Brazilians lured by booming hedge fund industry”.




Wilson, Dominic and Anna Stupnytska, The N-11: More than an

Acronym, Global Economics Paper:153, Goldman Sachs, March 28,


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