Hedge Fund Shorting Emerging Markets

June 18, 2014

Are Brazil and Turkey heading into recessions?

Emerging markets are making something of a comeback in 2014 after the Federal Reserve’s “tapering” comments triggered a disastrous sell-off beginning in May 2013. For example, the iShares MSCI Emerging Markets ETF (EEM | B-99) has eked out a gain of almost 4 percent this year after dropping by the same amount last year.

But not everyone is on board with the current rebound. To the contrary, Christopher Tsai, president and chief investment officer of Tsai Capital Corp., a long/short global equity manager based in New York, sees enough trouble in places from Turkey to Brazil and has enough conviction to actually be shorting the emerging markets altogether, and he uses ETFs to do it.

Tsai recently spoke to ETF.com staff writer Hung Tran about why he’s shorting emerging markets and why he thinks Brazil and Turkey are headed for a recession.

ETF.com: Can you give us some background about yourself and your firm?

Tsai: Our long/short fund launched in June 2011, and Tsai Capital Corp. has been managing money for primarily high net worth individuals and family offices since the beginning of 1998.

The long/short fund has about $28.5 million, and we also manage another roughly $20 million in separate accounts. Unlike a lot of other hedge fund firms, we prefer to invest for the long term. So we stay invested so long as the fundamental and the qualitative characteristics remain favorable.

We also believe in concentration as opposed to diversification, and that generally means that we prefer to hold 10 to 15 high-quality names. When it comes to shorting, we take a directional approach and we prefer to short indexes though ETFs, as opposed to just individual equities.

ETF.com: I also understand you have a very interesting financial background relating to your grandmother.

Tsai: My grandmother was a really interesting woman, and I wish that she lived longer than 93 years. Ruth Tsai was born in Shanghai, and she was the only woman to trade on the Shanghai Stock Exchange during World War II; basically from 1939 to, I believe, around December 1941 when Japanese troops came in and took over the Shanghai international settlement and the exchange was halted at that point.

But that was an amazing experience for her, because the Shanghai exchange was really the financial center of the Far East at the time. She told me when I was 10 years old that she traded everything from stocks, bonds, gold and other commodities.

So that was pretty amazing for a woman at that time, because most of those types of affairs were really handled by the so-called man of the house.

ETF.com: Which particular ETF or ETFs are you currently using to short?

Tsai: Since Tsai Capital focuses on companies with significant exposure to emerging markets, a natural hedge for us in terms of offsetting our exposure on the long book is to short the iShares MSCI Emerging Markets ETF (EEM | B-99), which is a very liquid emerging markets ETF.


ETF.com: What are you seeing for the rest of 2014 in terms of a big pullback in the S&P?

Tsai: We think that the bull market is very much intact. In fact, all bull markets in the U.S. have ended with some sort of burst of euphoria, and we have not seen any semblance of that yet.

Institutional investors remain wary, concerned that the market has run up too quickly without supporting fundamentals, and retail investors still have so much cash on the sidelines. Those are very bullish signs. We do think we are at the latter stages of the bull market, but the bull market still has legs, and it’s going to surprise on the upside.

That’s not to say we will not have a pullback from time to time, but I will note that every such pullback that we have had recently—and by “recently” I mean over the past year or so—it’s been muted.

ETF.com: Any tinkering you’re doing to your portfolio to position yourselves going forward?

Tsai: We take a directional approach to the short book, so, going forward—as long as we believe that the bull market environment remains intact—we plan on keeping a moderate exposure to the short side comprised almost entirely with EEM. Actually, we’ve sold short EEM not only as a hedge against our long book, but also because we see some worrying signs in emerging markets.

ETF.com: What sort of red flags are you seeing in EM?

Tsai: Emerging markets—including Brazil, China, South Africa, Turkey, among others—are slowing. And that’s despite positive growth from the U.S. and Europe, which are two very large areas of the world that affect the performance of emerging markets. So when the U.S. and Europe are growing and emerging markets are slowing, to me that’s a worrisome sign.

The return on equity and the return on capital for nonfinancial emerging-market-listed companies have fallen considerably. Per-share earnings for EM small- and large-cap and nonfinancial companies have flattened or are contracting.

We’re also seeing a rise in the yield, the interest rate of U.S.-dollar-denominated emerging market debt, particularly high-yield corporate bonds, and we’re also seeing yields rise in local currency government bonds. If that continues, we think another recession is possible in that area of the world, including Brazil, China, South Africa and Turkey.

I would add that the interest rate on high-yield corporate bonds has surged in China, particularly for three-year BBB+ bonds. The yield spread of a BBB+ bond in China over a comparable duration government bond has also soared. Elevated corporate yields and spreads for BBB+ bonds in China is a sign that borrowers are distressed.

And lastly, I should point out that emerging market private-sector external debt is very high in a number of countries, including Malaysia, Chile, Korea, Peru, Poland, Turkey, South Africa, Brazil, Russia, India, Mexico and Taiwan in particular.

This is borrowings by companies and banks from foreigners in foreign currency. Private sector external debt in South Africa is currently about 21 percent of GDP compared with 12 percent in 1996. Emerging markets as a whole, excluding China, are at about 20 percent of GDP. This is as high as the peak of the 1997-1998 Asian financial crisis.





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