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Developing an emerging market fund that protects investors

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One ingredient in developing an emerging market fund offering, says Luis Maizel, is being a good judge of character.

"I was in Brazil a few years ago and went to a presentation of Eike Batista," recalls Maizel, co-founder and managing director of San Diego-based LM Capital. "He was the wealthiest guy in all of Brazil and the first thing he said was, 'In five years I'm going to be the wealthiest guy in the world.'

"Right then, I decided I don't want to have a penny in any of his companies, because what he was interested in was himself and his personal wealth."

In January, Batista was jailed accused of insider trading and paying bribes, and has since seen his net worth tumble from an estimated high of $30 billion.

Maizel's been investing in developing markets for nearly three decades, concentrated in LM Capital's two fund offerings in high-yield and emerging market debt.

With $400 billion invested in emerging-market bond funds and the share of ETFs reaching 12%, according to Bloomberg, providers might be tempted to profit from a revived interest in the market.

But Maizel says deep active management-supplemented by local knowledge is essential in emerging market offerings, and is not easily manufactured or automated.
"I think that piece is something you cannot just run from an office in New York or in Chicago," he says.

Maizel spoke with Money Management Executive about the hard work involved in developing emerging market funds that protect their investors.

An edited transcript of the conversation follows.

Are advisers now more sophisticated in what they ask of emerging market fund providers?
Yes, what's happening is fixed income has always been a little bit of the ugly duckling of a portfolio, but it's a necessary thing, you need it for income, you need it for safety and it's the source of liquidity in the tough times. When fixed income was yielding 5% and 6% people were comfortable but when the coupon is making you 2%, the feeling is that the money you put in is not earning anything and you're just wasting time, until days when the markets drop dramatically.

So RIAs are using it as part of their asset allocation to its clients, but they are looking for fixed income without increasing too much he risk they're taking to get a better return. That's what we're finding. If you come out today with another traditional core fund, it's going to be very tough to find takers, but if you offer an alternative where they can still satisfy that need to have the fixed income piece of the portfolio, and they feel comfortable that you are not taking extreme risk but you're giving them returns, there is appetite.

Lately, emerging bonds are getting positive coverage. Can you talk a little bit about that story and how that affects providers like your firm?
Emerging countries are basically commodity-based and there is now a more sophisticated extraction in selling market for their products. They cleaned up their balance sheets dramatically from the time of the crisis of '94 in Mexico or Russia in 1998 or Indonesia in 2000. They were very unsophisticated markets and vulnerable to economic contagion - when one got sick, everybody started to throw up.

Now the markets have become much more sophisticated, much more independent and as their internal and local currency market developed, their appetite to tap the global markets has diminished the bid and their coverage has become much stronger. We're now at the point that sovereign emerging debt is no longer that attractive because the spreads have narrowed dramatically.

For example, at one time you could buy a government-sponsored enterprise in Korea and their quality was A or A+ and you could pick up 250 basis points over comparable U.S. paper.

Most of the money that has gone into emerging markets has gone into sovereign issues and our feeling is that space is a bit too crowded and the prices are too high. So there is definitely a slightly higher risk in emerging markets, especially if you are dealing with a dollar denominated paper because they don't generate the dollars, they have to earn them. In the U.S. they can print them, in emerging markets they have to earn them.

If you are going to go that route you should get a premium for it, and a premium of 20 basis points is not enough to take that additional risk. We're looking for 150 basis points and what makes sense.

Can you put into context the current political climate and how that affects your product?
You have to go industry by industry and company by company. For example, one of the companies we really liked was is one of the largest suppliers to the auto industry. If, for whatever reason, those cars are no longer made in Mexico and that market dries up, they will have to struggle to pay their obligations. So it's a company that we have to be careful with.

“Sovereign emerging debt is no longer that attractive because the spreads have narrowed dramatically.”

But Bimbo, the bread company, they are now in 27 countries, they generate around four times their need of dollars to meet their obligations, but their biggest market and domestic consumption is still Mexico, even though they bought Entenmann's and they bought a big chunk of Sara Lee's cake manufacturing arm. So they're an important company there and in the U.S. We're very comfortable with them, as they are solely profitable and they are global. So for us, getting a pick up in returns from a company like that is like getting a gift.

Are there countries weighted more in your portfolio? Do you consider some regions less prone to volatility than others right now?
We are very leery of countries that are leaning too much to the left or where there is a lot of power by one individual to make a change. You can do all the analysis and check the financials, but one decision by the president will change everything, we stay away from that market.

We don't do anything in Venezuela, for example.We don't do anything in Nicaragua, we don't do anything in Ecuador. When the outgoing president came in, three days after he took power he announced that the previous administration did not ask permission from congress to issue dollar denominated debt, so he was not recognizing that debt. And the paper went from 103 to 31 cents overnight.

So we definitely avoid that. When Colombia was being run by the drug dealers, we didn't have anything in Colombia. After they reached a truce and cleaned up their act, Colombia has become very attractive. Peru had a leftist government that was unreliable. They changed governments, we re-analyzed the country and the country looks great. So Peru is now one of our main areas of investment.

For clients looking for investment income, these funds excelled in the first half of 2017.
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We love Chile, but Chile is so strong and things are doing so well that there is very little pickup in spread. So we have a little bit in Chile, you know, we love it but we don't get a lot of advantage of investing there. Brazil used to be the country where we had the most investment until this corruption scandal broke out. This carwash investigation, it's tainted almost everybody. So we're being very careful about what we do in Brazil now.

Do stories like that complicate the job for your firm as a product provider? Does it make it harder to explain the market to an investor or adviser?
It does, but, at the first smell of problems or corruption we get out. We'd rather see it as spectators from the outside than waiting inside and seeing what happens.

In emerging markets, not only Latin America, but throughout the world, you are still investing in the family. Most of the companies, about 80% of them are still controlled by the founding family. They have started to borrow money in the open markets for liquidity purposes, for estate purposes, but they are still running the enterprises as they were their own.

You need to do more research than just checking their financials. You need to be sure that you're funding a new factory or a new product line and not a new yacht for the family or a new G6. And that the management is really looking after the investors and not after themselves.

“You need to do more research than just checking their financials. You need to be sure that you’re funding a new factory or a new product line and not a new yacht for the family or a new G6.”

So outside of the financial planning you have to do a lot of individual checking. We've developed, I think, a very solid network of people there and before making any investment we check on the moral fiber that makes management, whether there's a succession plan, whether the people running it are honest, what they've done in the past, whether they have a history of screwing investors.

I think that piece is something you cannot just run from an office in New York or in Chicago.

Are managers so easily blindsided?
There's a gentleman in Mexico that is supposedly the second wealthiest Mexican, Ricardo Salinas, he's got two public companies that trade in the U.S., the second-largest TV chain and a chain of department stores called Elektra. And they are well perceived in the U.S. by most managers that don't know him well.

But this guy has already gone twice to chapter eight. So anything that has his signature we stay away from. I got a question from a client recently why we didn't we own any of his paper in our portfolio, and when I explained it they were very appreciative, saying, "You are protecting us from what he might do."

Has your firm ever considered an ETF offering?
Launching and ETF is a very expensive proposition, you require a lot of advertising and promotion and I think what we want to walk before we run. We've spent a long time developing our product, we've been doing this for 27 years now, but we don't want to jump into new ventures until we're very solid in the ones we're starting. It is something that we've thought about but time will tell.

I will add, this is an area where the active against passive doesn't really work that well. It is very hard to find an index that will have this and it's very hard to benchmark.

Many times the issues are $200 or $300 million together, they're not the billion dollar issues as they are in the U.S. So it's one of the few areas where, first, there is no real benchmark I guess to where you can compare it to, and secondly, active management does make a difference. You cannot just take X from X country, as in emerging markets, not everybody is created equal.

You've learned to be very cautious.
We will always look for risk adjusted returns. It's not necessarily the absolute number, it's a portfolio and the product that will span the bad times as well as do well in the good times. It's been the motto we've lived by for a long time.

Sometimes in the really, really good times people will say, well, your competition outperformed you by 14 basis points and we say, yes, but in the bad times we outperform them by 100.

So that's really important, when you are in fixed income you are not really gambling. Fixed income is the solid part of your portfolio and it's important for you to keep that in mind.
The total return funds that have become really a hedge fund are not a fixed income product. And we really maintain our fund and our portfolio as fixed income. Something that you can keep without worry. Each one of the products we can explain to you why we have it and why we sleep well having it.

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