Brazilian hedge funds wiped out three weeks of gains in a single day after betting on wrong election outcome

Brazilian hedge funds that had bet on a right-wing victory in the country's presidential election suffered massive losses after the result defied their expectations.

Some funds saw their returns collapse by more than 30% in a single day. Investment strategies built around predicting how stocks, currencies and interest rates would move based on the election outcome unraveled, sending shockwaves across Brazil's financial markets.

According to Yonhap and Bloomberg, Brazilian hedge funds sustained heavy losses after President Luiz Inácio Lula da Silva scored an unexpected victory in the presidential runoff held Sunday.

The funds had loaded up on equities and other risk assets in anticipation of a win by right-leaning candidate Flávio Bolsonaro, but the result came out the opposite of what markets had expected, causing investment losses to snowball.

Just three weeks earlier, the mood had been entirely different. When Flávio Bolsonaro — the eldest son of former President Jair Bolsonaro and the Liberal Party (PL) candidate — defied expectations to finish first in the Oct. 4 first-round vote, Brazilian financial markets rallied.

With the prospect of a right-wing candidate taking power looking increasingly likely, some hedge funds posted their biggest gains in years.

What investors were focused on at the time was Bolsonaro's fiscal policy platform. Expectations spread that a Bolsonaro victory would lead to a reduction in the country's large fiscal deficit and create conditions for interest rate cuts.

On the basis of that outlook, hedge funds placed bullish bets across multiple asset classes — stocks, currencies and interest rates. They anticipated that improved fiscal health would push market interest rates lower, lift the share prices of domestic companies struggling with high borrowing costs, and strengthen the Brazilian real as foreign capital flowed in.

Lula's runoff victory shattered those strategies in an instant. As investors rushed to dump assets after a result that overturned the predictions of most polls and market forecasters, Brazil's financial markets fell into turmoil.

Losses were concentrated particularly on Monday, the first trading day after the election. According to Bloomberg data, Vista Capital's Multi-Estratégia fund tumbled 24% that day. Encore Asset Management's equity fund recorded a loss of 32%. The Legacy Alpha fund and the Ace fund fell 8% and 9%, respectively.

Funds that had concentrated their capital on rising share prices were hit hardest. João Braga, a portfolio manager at Encore Asset Management, said the fund had been heavily skewed toward equity purchases right up until the market plunged. Low cash holdings and high exposure to expected share price gains left the fund poorly positioned to respond to the sudden selloff, Braga added.

Braga said the investment decisions at the time were based on polling results, first-round vote tallies and the firm's own analysis of voter behavior — all of which had pointed strongly toward a Bolsonaro victory.

Ricardo Denadai, founder of Ace Capital, also said the unexpected election result inflicted heavy losses across stock, foreign exchange and interest rate positions. Denadai said the far greater market volatility following the runoff compared with the first round made it nearly impossible to avoid losses.

Underlying the market's sharp reaction to Lula's victory is concern about Brazil's deteriorating public finances. Investors worry that the Lula government will prioritize social welfare spending and consumption-boosting policies over aggressively addressing a fiscal deficit that exceeds 9% of GDP.

The episode is expected to add further strain to Brazil's hedge fund industry, which was already struggling with capital outflows. A prolonged period of high interest rates has driven investors to shift money into government bonds, which offer relatively stable returns.

Brazilian hedge funds recorded net outflows of 9.3 billion reais ($1.72 billion) from January through September this year. The industry has now seen capital outflows for four consecutive years.

Voices within the industry are calling for a rethink of existing investment strategies. Artur Wichmann, chief investment officer of XP, one of Brazil's leading hedge fund managers, warned that funds risk losing even more market influence if they fail to drive change themselves.

Market participants are now turning their attention to the Lula government's economic policy agenda. The appointment of a new finance minister and the specifics of any fiscal consolidation plan are seen as key variables in restoring investor confidence. However, given the scale of the shock from the election result, analysts say it will take considerable time for financial markets to stabilize.