Emerging market credit hedge fund ProMeritum positions for success

^{By Hugh Leask}

After successfully weathering three-and-a-half years of near-continuous shocks and crises, ProMeritum Investment Management, a London-based emerging markets credit hedge fund, sees a rich opportunity set evolving within its investment universe, as macro uncertainty gives way to a fresh range of trading ideas and a sea-change in investor sentiment.

“We have never had as many investment themes in our portfolio as we do now,” Pavel Mamai, co-founder and managing partner at ProMeritum Investment Management, told Alternatives Watch.

Mamai said 2023 is proving a “completely different environment” for the fund's investment strategy, which trades idiosyncratic, proprietary themes and ideas across a mix of emerging markets sovereign and corporate credit, local currencies and fixed income assets. The COVID-19 pandemic and the Russia-Ukraine war have brought many more dislocations across emerging market assets, he explained, which in turn in is creating new investment opportunities for ProMeritum's strategy across Eastern Europe and the former Soviet bloc, the Middle East and sub-Saharan Africa.

“We have never been as busy looking at different situations as they are now. On the one hand, the more stable macro environment allows you to explore the situations and not get distracted on macroeconomics, and on the other hand, there are simply more of these situations,” Mamai said.

Observing the continually evolving market landscape, he said the strategy switched from the capital protection it adopted during between 2020 through mid-last year towards a more returns-generation mode.

“Right now, things are still driven by the macro picture, but the variety of different potential outcomes of the main macro parameters has significantly declined,” explained Mamai, who prior to establishing ProMeritum in late 2014 had held EM-focused roles at Goldman Sachs, Nomura, Lehman Brothers and Renaissance Capital.

“The macro volatility has subsided. It seems volatile on a daily basis, but if you look at weekly or monthly numbers, it's not as high, and that is good for our strategy – it means that idiosyncratic alpha can be harvested.”

Managing some $350 million in assets, ProMeritum’s fund – which has never had a down year since launching in January 2015 – is up 3.6% year-to-date in 2023, which came on the heels of a 4.53% annual gain in 2022. By comparison, the benchmark dollar-denominated JP Morgan Emerging Markets Bond Index Plus Index – which tracks liquid fixed and floating-rate EM sovereign debt – fell 16% last year, and the local currency-denominated JPM Government Bond Index (Emerging Markets) lost 12%.

Though ProMeritum does not comment specifically on fund performance, Mamai acknowledged that 2022 saw the fund generate its largest-ever amount of alpha since inception. It did this by avoiding the fall-out from the global equities and rates sell-off, while successfully hedging against the rising rate environment and focusing on opportunistic, idiosyncratic bets in target markets.

Opportunistic short themes

These included a short position on Zambia's debt, a handful of opportunistic trades in local market rates and FX in South Africa and Hungary, a short position in Egypt, and an idiosyncratic bet in Turkish credit prior to the country’s elections. Now, the number of themes and ideas emerging this year is “probably even larger,” according to Mamai.

One key theme for this year relates to liquid local markets, particularly in countries such as Poland and Hungary which increased interest rates quicker than the G7 nations, as well as certain countries such as South Africa where inflation was less pronounced.

“Some of these countries will likely pivot, and start cutting rates earlier than G7 central banks, and that’s what we are now watching very carefully,” Mamai said of the idea. “The liquid nature of these markets allows us to be very tactical there - we don’t need to build an exposure and wait for something to happen.”

Another bet relates to weakening credit quality among certain emerging market sovereigns. “What you see is some sovereigns migrating from high yield into stressed, and the spreads have widened significantly,” Mamai said. “Some of these sovereigns get bailed out either by the IMF or, in terms of the quasi-sovereigns, by the sovereign itself.”

Among these ideas are Tunisia, which has received external financing, as well as bets relating to debt restructuring in Sri Lanka and Ghana.

Fruitful new realities

A third cluster of themes stems from secondary dislocations relating to the Russia-Ukraine war. “Here we have exposure in Serbia, where generally a very strong, quasi-sovereign could not get a Eurobond done due to sentiment, so we provided some bridge financing. We also have FX exposures in Uzbekistan and Kazakhstan.”

Mamai noted that his strategy no longer has any exposure to Russia or Ukraine, which have traditionally been key components within its portfolio.

“We believe that under the current regime, Russia is uninvestable, and in Ukraine, it’s very difficult to forecast the end of this tragic conflict,” he explained. “Once the conflict has ended, and the reconstruction effort starts, Ukraine will become very important for us. But before we see that, we’re going to be on the sidelines.”

Reflecting on the market upheaval of recent years, Mamai said 2020 and 2021 had been defined by larger macro events centered around the COVID-19 pandemic, which made it tricky for ProMeritum’s investment approach.

“Nothing was idiosyncratic about 2020, but we still did quite well because we managed to keep our losses in March ‘20 very manageable, as even from mid-February we took the view that the pandemic could be a very significant crisis. So essentially, we tried to sell all exposure and hedge our book,” he said.

“2021 was more difficult. We did quite well in the first half, because it was a continuation of 2020, but then again in emerging markets the impact of rates moves and inflation in the U.S. was felt earlier than in developed markets. However, the second half was much more difficult and more challenging for us because our idiosyncratic themes were impacted by macro moves.”

In 2022, the firm started to develop more sophisticated ways of hedging macro risk, and as macro volatility declined, more idiosyncratic plays have come into view. Ultimately, 2022 was the year where all of the firm’s efforts started to bear fruit, Mamai added.

In the run-up to Russia's invasion of Ukraine, the fund had been short certain Russian assets, as the firm saw “little value” in Russia.

“While we had an 11% long position in Ukraine one week before the invasion, on the day of invasion, we reduced it to 4%. We also increased the Russian hedge by four times within three days,” Mamai recalled. “We also added portfolio hedges, such as long oil and long U.S. treasuries, and periphery hedges such as selling Polish currencies. That allowed us to protect our investors’ capital from this event.”

He added: “We dodged the Russia-Ukraine war, and generally with our idiosyncratic themes, we believe that the hedging strategy allowed us to keep those themes in the book and they performed quite well in the second half of last year.”

One big change since 2020 is the diminishing role played by pure corporate credit in the portfolio due to the liquidity of these assets. “We have been phasing out corporate credit and increasing our presence in local rates, specifically local currency sovereign exposures.”

Turning to prevailing allocator appetite, Mamai believes there has been a “sea change” in investor interest for the strategy this year.

“Up until last year, fixed income-based strategies were not popular - everybody was looking for the highest beta strategies, or towards crypto, or towards private assets or venture capital,” he said. “But conversations have now changed. After last year, allocators are now thinking about how they need to reposition themselves. Fixed income has become more prominent on the minds of investors, due to the sheer level of income and yield it provides. That clearly benefits us, as investors are placing significant value on managers that didn't lose money last year.”

ProMeritum’s investor base is a mix. “What we see is that our strategies are particularly popular with two types of investors – pensions and multi-family offices,” he added. “They appreciate the risk management and our ability to protect investor capital in difficult markets.”

With rates rising from zero to 5%, there is now significant added pressure on managers today to deliver performance. But Mamai is confident the strategy can generate higher absolute returns as the firm approaches a decade in business next year.

“It has been a challenging number of years, but we’ve stayed in the game, we have protected our investors’ capital, and we have generated the performance which was possible in this environment,” he said. “We’re looking at the world with much more optimism now with regards to our business. Success always comes after challenging times.”

_{This article, “Emerging market credit hedge fund ProMeritum positions for success,” was originally published on June 27, 2023 on Alternatives Watch and is republished here with permission from BMV Digital, Inc.}