Separated by less than three miles of affluent suburbs, the two main business areas in São Paulo represent two faces of the city’s businesses.
Avenida Paulista once housed the frenchified mansions of the coffee barons who put the city on the map in the 19th century. Established, but challenged by newcomers, it houses the private banking operations of Banco Bradesco and the offices of Joaquim Levy, chief executive of asset management arm Bradesco Asset Management (BRAM).
Down the hill is newer, brasher Itaim Bibi. The once-suburban area has seen a rash of plate glass skyscraper constructions that offers a neat sketch of the city’s chaotic and architecturally-eclectic real estate boom. The younger, more thrusting Advis Asset Management is thriving in this New York-style environment.
Indeed, the two managers could hardly be more different.
BRAM is part of one of Brazil’s two giant private retail banks. The asset management arm has amassed R$280bn much of it collected from the conservative bank’s retail and corporate clients. Its parent has resolutely eschewed the foreign adventures of competitors and focused on growth at home, keeping a tight rein on its plump balance sheet.
Levy is a newcomer both to the asset management industry and BRAM, joining both in 2010, brought in from outside to shake the place up a bit. Nevertheless, he is a thoroughbred representative of Brazil’s financial elite. Honed in the public sector, he has spent his career shuttling between the States and Brazil. A Doctorate in economics from the University of Chicago was followed with stints at Washington-based development banks interspersed with key periods in Brazil, including as secretary of the Federal Treasury.
Has this given him an intimate knowledge and a feel for how public sector institutions work? “In some cases, it has been easier for me to understand their policies. I picked up very early on that the new Central Bank team [in place since the start of last year] would be much more assertive in its monetary policies than the previous administration,” he says.
BRAM is focusing on riding the wave of Brazil’s expanding range of assets and related increases in risk. The manager is beefing up quantitative and qualitative systems and research. Home grown talent is emphasized. Analysts are promoted to fund managers and continue to meet company management giving continuity. “We look for thorough approaches: some creativity but not too much,” says Levy.
Efficiencies and risk control are vital. The bank is developing a unique equities partnership with Bloomberg to route trading orders from fund managers to a separate trading desk, which is not a common practice in Brazil, with a prior screening for compliance, says Levy. As risk creeps into the Brazilian market through new instruments, gradational and systemic controls are vital. “Fund managers got a bad rap in Brazil because they did not adequately control risk management. We are prioritizing quantitative tools, a culture of risk management and deep market expertise,” he says. “It’s not so glamorous but it’s a real priority for us”.
At the other end of the scale, Advis started life as a multi-family office in 2005 and is a minnow compared to BRAM with R$9bn under management. A full 90% of that is in macro funds with the Delta strategy investing globally and Enduro taking a more Brazil-focused approach.
The house is an unusual combination of talents. Co-CIOs Alexandre De Zagottis and Eduardo Bodra met at Colégio Bandeirantes, a high school that produces math whizzes. The former went on to MIT and gained a PhD in Economics at Fundação Getúlio Vargas. He had the obligatory spell at McKinsey & Company and then at his family business, Droga Raia, which he prepared for an IPO that market whipsawing prevented.
Bodra, meanwhile, has one of those stratospheric careers that are not so uncommon in talent-starved Brazil. Short stints at ING Asset Management and Banco Fator were followed by a decision to do an MBA at INSEAD to gain some international experience. Days before he packed his bags, Itaú called him up to be the head trader of one of its desks. He was 29 and never did make it to Fontainebleau. Later, after a difficult experience at fund manager Vision, he launched his own fund with personal and friends’ money and then joined forces with his ex-alumnus.
Advis macro funds have three core characteristics. “We never bet on only one strategy but use several strategies to extract alpha from combinations. We don’t think we have an edge in any one.”
Fund managers invest for the long-term and so: “If you call me and ask ‘what are you thinking about markets for tomorrow,’ nine times out of 10, I am not thinking anything,” says Bodra.
And managers leverage up to three times, primarily through options, a relatively little used practice in risk-averse Brazil. “There’s no way you can achieve 15% over benchmark without leverage. We are in the top three or four in Brazil in terms of volatility but compared to international funds, we are average with about 7-8% volatility”.
In common with BRAM, the fund takes risk management seriously. It considers the issue in three dimensions -- market beta, volatility and tail risk -- which define the size of positions, says De Zagottis. The fund generally seeks to hedge out beta; always looks for volatility that is consistent with confidence; and hedges excessive fat tail risks, usually through options.
Change in the air
Traditionally, Brazil’s asset management industry has been dull. Sky-high interest rates made investors risk-averse. The overnight inter-bank rate, the CDI, an almost universal benchmark for funds has been a particular millstone. “It is not rational to take risks when you have, say, 15% risk-free rates,” says Bodra.
Even when they did dip their toe into riskier assets, Brazilian investors were jittery. They would pull money for even very short periods of underperformance abetted by legislation that requires liquidity and the publication of daily net asset values and discourages lock-in periods.
That meant Brazilian boutiques had to be built to survive an exodus of funds. At Advis “we structured ourselves to survive whatever happened to our asset base. That means low operational costs and wages. The vast majority of remuneration comes through variable bonuses which are 100% dependent on performance,” says Bodra. Fifteen key executives have equity-linked compensation.
There are seismic shifts though. Under the dovish policies of Alexandre Tombini, president of the Central Bank since last year, the overnight Central Bank-set Selic rate has fallen from 12% last August to 7.5% and Brazilian investors realize they need to take risks if they are to maintain yields.
Today, there’s an air of excitement as the funds industry shifts up a gear.
It was clients that wanted BRAM to launch funds with delayed redemptions. Resistance came from inside. “Our private banking, institutional and even some corporate clients wanted lock-in periods for higher returns. The distribution team were like ‘oh my God’ when they found out,” recalls Levy. BRAM has a fund with a 90-day lock up that has already raised R$1.5bn. But he has to tread warily and educate clients. “It’s a real trick for managers like us not to jettison long-term values. You have to make sure these new products are sold to appropriate clients,” says Levy.
Rates, rates, rates
Given that Brazilian fund managers have 90% of assets in fixed-income, a knack for predicting rate movements is essential.
It has long been a no-brainer to assume that Brazilian rates would keep declining in the long-term. With real rates of just over 2% at the short end today, that does not look so certain. “Market risk will make a comeback in the near future. For the last 18 months, it has been eclipsed by credit risk,” says Levy.
Still, neither BRAM nor Advis see CDI rates ticking up soon despite the futures market pointing to slightly higher rates with January ’14 contracts at 7.79% in mid-September.
Levy sees some risk factors but does not see increases until late next year. He sees inflation staying close to 5% arguing that global conditions are keeping a lid on inflation. Loose monetary policy from the Federal Reserve and the European Central Bank will continue through 2015, he thinks.
Felipe Niemeyer, partner at Advis, sees local rates staying low too and indeed one of the firm’s guiding long-term themes is the convergence of Brazilian interest rates to international norms. A period of slow growth in the developed world and China will keep commodity prices in check. “The international scenario has a deflationary effect on Brazil as global growth will remain low and commodity prices will stay cool.” Better domestic fiscal policy helps, adds Niemeyer.
The managers agree on short-term rates, but not the yield curve and longer term differential between fixed-rate and inflation-linked bonds.
Levy sees steepening in the Brazilian curve in the long term as recovery takes hold in the US especially if China is able to realize its shift from an economy led by investments to domestic growth. But, he warns: “duration in Brazil is so short that even if you believe there may be steepening, say beyond five years, it is not easy to play this in our markets,” he notes. The maximum duration for most BRAM funds is three years.
With duration bets limited, BRAM favors the large and liquid inflation-linked bond market. “It’s a privilege to have NTN-B bonds [linked to consumer price indexes]. They are a flexible instrument and we have some exposure in most of our portfolios,” says Levy. BRAM remains cautious about more aggressive strategies using derivatives although that will come. “In the future, we will see much more diversified positions and a large use of derivatives, including futures and options to leverage,” he says.
Niemeyer, however, sees the Brazilian yield curve flattening as Brazilian rates converge. “Compared to other emerging and developed markets, Brazil still has this very steep curve,” he notes. Advis macro funds have been overweight Brazilian inflation-linked bonds, but are moving out on the curve in nominal rate instruments. Break-even inflation rates, the difference in yield between inflation-linked bonds and conventional bonds, suggest average domestic inflation of 6% right through 2020. That implies increases in inflation, a scenario he thinks unlikely as it would trigger the Central Bank to raise rates.
It is not so much the tried and tested government bond market that is making Levy sit up and take notice but development of corporate and securitized bonds. For now, these markets are negligible compared to the size of Brazil’s economy.
A key to stimulating this market is the BNDES, Brazil’s outsized National Development Bank, which has muffled private sector investment. It has a larger lending portfolio than the World Bank and is often seen as cherry picking the best for its portfolio. Levy sees real change. “As a former Treasurer, I do appreciate that the BNDES is very protective of its role … But it cannot keep carrying everything on its balance sheet. It is becoming a major partner in the development of capital markets”.
BRAM has already moved fast into high quality corporate bonds, he says. For now, issuers pay virtually undifferentiated rates because only the most highly-rated companies come to market and there have been few cases of defaults. “Now that overnight rates are lower, you will see more companies access the market and we are going to get that differentiation,” predicts Levy. He expects to launch funds in higher yielding instruments.
One thorn is the troubled small banking sector. Banco Cruzeiro do Sul is just the latest case of fraud which has led to Central Bank administration and now liquidation. Bonds have traded as low as 15 cents on the dollar with a lack of clarity on treatment of bondholders. Levy sees the sector’s problem as structural: smaller banks rely on wholesale markets rather than deposits. “Small banks will have to be rethought: they need to be very conservatively managed.”
Development of corporate credits depends on a liquid secondary bond market, something that has eluded Brazil. Levy is confident that: “we are going to get a good secondary market soon – maybe next year or at least by 2014.” That will help bolster securitization, which is already popular with a veritable wild west of options from farmland, consumer credit, and even unpaid legal payments owed by the Federal and state justice systems.
If BRAM is focused on home markets, Advis hunts for trades in the intersection of international and domestic situations. Brazil is caught up in the crosswinds of the global deleveraging trend and its corollary, monetary easing. High interest rates have long made Brazil an enticing destination and put upward pressure on the real, says Niemeyer. Finance Minister Guido Mantega has already proven willing to discourage this hot money in the bond market by hiking taxes on foreign investment in 2009-10.
Advis and Levy both reason he will not resort to such measures again. “The government wants to diversify its investor base, refinance debt cheaply, and extend out along the curve. It is keen to develop a global market for local currency debt and remember Brazil still runs a current account deficit,” says Niemeyer. He expects more orthodox intervention, through the spot and forward markets, and reserve accumulation.
Levy agrees that the government is reluctant to use taxes on foreign investors. “I think that in the medium to long-term, it’s natural for the real to appreciate somewhat. But you have to be careful in the short-term of over appreciation driven by capital flows. The government is managing that with the fewest dislocations possible”.
Mantega will have to get used to low global rates: they are probably here to stay, the managers agree.
Indeed, the second of Advis’ main themes is deleveraging and a long crisis in Europe. “We are going through a huge cycle of deleveraging across developed markets. It’s going to take a long time to solve this and loose monetary policy, such as QE3, just holds the process back,” says Niemeyer .
Europe and the euro will suffer prolonged low growth and deflation with growing differentiation between core and peripheral markets. “It is most likely a Japan scenario with weak growth and low or negative rates,” he says. In 2010, the fund was long European bonds and short equities in a low growth environment.
When the Central Bank turned dovish and started cutting rates last year, the fund changed tack. Advis covered shorts in European equity markets and realized profits in bonds. Today, a significant conviction trade is against French bonds. “If you have spillover from peripheral markets to the core, France is in a dire situation. It has low growth, a high deficit and a still-weak economy,” says Niemeyer. There’s a 20% probability French bonds could spike to 2-2.5% over bunds, 60% that they will reach 1-1.5% over and just a 20% chance of little movement.
Advis seeks to hedge key conviction trades. For example, the fund balances short positions in French bonds with long positions in Brazilian debt. “Even if the global economy recuperates, which is not our core scenario, French bonds would sell off more than local Brazilian bonds.”
The main bet is a short position in euros. This is done through a small cash position, some options at the money and some exotic options. The fund bought some very cheap puts on the euro with a knock out on realized volatility. “When we bought them in 2008, annual volatility in the euro-dollar was 16% per year and the market was nervous that it would move higher. The fund bought euro-dollar puts at 130 with the knock out at realized volatility of 17%, a 70% discount from plain vanilla. We were betting that that level of volatility would not be realized as we see a long process of steady depreciation and not a one-time fall,” says Niemeyer. So far, that has proven to be an effective bet.
Brazilian equity strategies at both houses are developing fast although for both they represent less than 10% of total assets.
Over the last 12 to eighteen months, the most successful strategies have been to focus on the second tier of companies oriented to domestic growth, says Levy. The Brazilian economy has been relatively robust and such companies are much less vulnerable to huge recent global emerging market asset allocator shifts. BRAM’s dividend, small cap, and infrastructure funds are all doing well, he notes.
Dividend funds are especially popular both globally and in Brazil, he notes. “Investors appreciate companies with real assets, clear profits and cash flow and avoid unproven businesses. Just look at Facebook”. Brazil’s well-developed infrastructure companies are doing well because they have these characteristics and many have a natural hedge against inflation as contracts are tied to price indices. Moreover, the sector is growing with the government prioritizing logistics, he says.
Levy is keeping a close eye on the government’s concessions program and believes that contracts will be attractive. Many critics say some previous contracts have not been. “The government is listening to the private sector. It is pragmatic and not ideological. As everything in Brazil, a middle ground will emerge,” says Levy.
Logistics firm Ecorodovias has good management, a clear business plan, and a track record with flexibility and fit into many of the more conservative utility, infrastructure and dividend funds, says Levy. Specialist Mills Engenharia has a number of business lines related to engineering public works: “When you have a tricky job, you get Mills in for the most complex part,” says Levy. A fledgling subsidiary machinery and parts rental company is rapidly proving a success too. “They are top people in terms of business, engineering and management and it’s a very clear and transparent business and operations,” he says.
The other theme is consolidation, which has already taken place among drugstores, he notes. In most sectors in Brazil, the three largest companies typically account for a much smaller market share than in the US or Europe. The healthcare sector has great consolidation potential especially medical diagnostic companies. He is also eyeing M&A in pulp and paper companies. “You have to keep your ear to the ground all the time,” he says.
Advis tends to take long positions by buying the Ibovespa index for macro funds and Niemeyer is confident that the index will rise. The commodities-heavy index also helps hedge conviction positions. “If there is a pick-up in commodity prices, you will see an inflationary impact in Brazil. That could hurt our bond positions, but benefits our Ibovespa index holdings,” he notes.
The Brazilian macro strategies incorporate some alpha stock ideas. Education company Anhanguera should deliver double digit top line growth and substantial margin expansion over the next few years based on occupying spare capacity in their classrooms by increasing enrollments with the help of low interest government financing for students.
Brazilian asset managers have focused too long on lucrative distribution, hoovering up savings and parking them in overnight rates while creaming off a hefty fee. Higher risk-taking strategies were confined to a fringe of specialists, vulnerable to implosion in the event of just a couple of months of underperformance.
Lower rates change the game plan. Brazilian supermarket BRAM with its retail client base is eagerly diving into the range of new asset classes that go from corporate bonds to the alphabet soup of securitized assets to mid-cap stocks. Diversification, deep research and risk control are the watchwords.
Advis thinks its core macro strategies have plenty of room to grow and diversify and is adding equity capability. “We want to do better what we already do today. There is space to be bigger than we are today. Big funds run US$20-30bn. Looking at that, we are confident we can grow,” says Bodra.
Both will benefit from more liquid and transparent markets at home. Most of all, they will benefit from the trend to embrace risk by Brazilian investors and more willingness to try out new strategies. Change is in the air.