Monthly Highlights: October 2008

•  Extreme portfolio losses in Nigeria and Zimbabwe
•  Hedge opportunities were limited by exogenous factors — most notably heightened counterparty risk
•  Broad-based weakness as forced selling and fund redemptions weighed on African equity markets
 

Extreme portfolio losses in Nigeria and Zimbabwe

We are extremely disappointed by the degree of downside risk captured during October’s massive sell off. The Portfolio was exposed to broad-based weakness with nearly every individual market contributing to the monthly decline. In Nigeria, the Nigerian Stock Exchange (NSE) removed its -1% downside limit on 28th of October, and most Nigerian equities declined at a rate of -5% per day for the final four trading sessions of the month. Despite our efforts to reduce Nigerian country exposure, liquidity conditions have deteriorated sharply with daily volumes plummeting by more than 80% since NSE implementation of the 1% circuit break on 27th of August. In Zimbabwe, currency-related weakness ran to extreme levels with depreciation of the Old Mutual Implied Exchange Rate weighing down portfolio gains in the underlying equity market. As previously discussed, Zimbabwe is the most volatile country in the Portfolio, and we view underlying exposure as a binary option with favorable risk/reward characteristics and positively-skewed asymmetric upside.

Hedge opportunities were limited by exogenous factors — most notably heightened counterparty risk

In the face of contracting global liquidity, we have made numerous attempts to identify and isolate profitable hedge opportunities. On the short side, we felt that many of the opportunities available would have exposed the Portfolio to significant counterparty credit risk given the recent spate of global bank failures. In addition, many of the liquidity pools and lending facilities we had successfully accessed in the past were materially impacted by the recent crisis. As such, we were left with little choice other than to improve our underlying cash position and allocate away from assets with significant exposure to the global financial crisis. Furthermore, available FX and equity hedges grew extraordinarily expensive following the deterioration of bank balance sheets. In FX, bid/offer spreads across major African crosses widened by nearly 200% as most primary dealers were unable to provide firm quotes amid sharply rising currency volatility. In equities, we grew increasingly concerned with the viability of EM equity index hedges as African equity markets had previously exhibited only marginal correlation to the broader emerging market universe. Specifically, the MSCI EFM Africa ex-SA Index (USD) had outperformed the MSCI EM Index (USD) by nearly 1800 basis points leading into October so the risk of spread compression was deemed significiant. In the end, we concluded that index-related hedging strategies were far from perfect and recall events surrounding the Asian crisis of 1998 when EM managers hedging with S&P 500 index shorts were quite suddenly exposed to extreme losses when the US and Asian equity markets decoupled.

Broad-based weakness as forced selling and fund redemptions weighed on African equity markets

Looking ahead, we remain firm in our belief that consistently positive risk-adjusted performance will be driven by bottom-up investment in African companies with excellent fundamentals and strong management teams. We believe that recent events have created a fundamental mismatch and presently attractive valuations will prove unsustainable over the long-term. Yet over the near-term, investors remain largely risk averse and are likely to remain on the sidelines until much of the forced selling has subsided.