Emerging markets stocks have gone from satellite to core holding in the past 10 years amid superb long-term performance. Morningstar's diversified emerging markets category of mutual funds returned 13.8% annualized for the 10 years through September 2011.
Latin American stock funds led the way with an 18% annualized return for the period. This is a relatively small category, with about $9 billion of assets spread among 11 mutual funds, but recent developments may lure a larger share of investors' portfolios, despite a recent retrenchment.
Latin American equities were out of favor in the late 1990s, says Adam Kutas, who manages the Fidelity Latin America fund. The scant buying interest was due in part to financial crises and currency devaluations in Argentina and Brazil.
"Many investors thought Brazil was a basket case," Kutas says. "In addition, commodity prices were at a 30-year low then." Low commodity prices generally are bad news for resource-rich Latin America. Will Landers, portfolio manager of the BlackRock Latin American fund, adds that inflation in Latin America was a major concern 10 years ago, helping to depress prices.
But Brazil changed course and proved the naysayers wrong, driving the dramatic turnaround in Latin American stocks. During the past 10 years, Brazil has surged to about 70% of MSCI's Latin American index from around 30% of that index, according to Kutas.
The iShares MSCI Brazil Index fund posted extraordinary total returns for 2003 through 2007: 116%, 34%, 52%, 43% and 75%. After a 54% wallop in 2008, this ETF boomeranged, roaring 122% in 2009, plus a much more modest 8% in 2010. Other Latin American stock funds tend to be heavily weighted toward Brazilian companies, and they have joined in the ascent.
Why has Brazil prospered? Landers cites three main reasons. "One, the central bank of Brazil has established an inflation target," he says. "Two, fiscal discipline has become a given, thanks to legislation that prevents government agencies from running a deficit. Three, Brazil's currency now trades freely, so the currency takes the brunt of any economic instability." Inflation has come down from double digits, which Landers says has been a game changer for Brazil's economic prospects.
With this framework in place, Brazilian companies have been able to cash in on worldwide trends, including the increase in commodity prices. "In the last decade, China has become a huge importer of global commodities," Kutas says. Brazil, a major exporter, has been among the prime beneficiaries of China's thirst for natural resources.
Even as commodity prices have risen this century, and Brazil's commodity exports have surged, the overall Brazilian economy has become less dependent on exports. "In Brazil now," Landers says, "the main driver is the growth of the domestic middle class. Credit has become available and affordable, which benefits many domestic industries."
Eric Anderson, head of Latin American equities for ING Investment Management U.S., agrees. "Thirty million people are expected to enter Brazil's middle class. That's good news for all sorts of Brazilian companies, from financials to health care to retailers."
Booming exports have enabled other Latin American countries to pay down debt, Anderson says, so they've been upgraded by credit ratings agencies. "In Latin America, the average ratio of debt to GDP is much lower than in developed countries. The region now has excellent credit and healthy macroeconomic fundamentals."
Ongoing regional prosperity does not necessarily translate to perfect stock market performance. In early October, Latin American mutual funds were showing year-to-date losses of 23% to 30%. The biggest fund, iShares MSCI Brazil Index ETF, was down nearly 32%.
Why have Latin American stocks fallen so hard this year? Kutas points to valuation after so many years of superior performance. "Earnings expectations were so high it was likely that surprises would be on the negative side."
Some of this year's slump also can be blamed on fears about the global economy. "If Europe is down, that could hurt Brazil's exports," Anderson says.
Latin American stocks also are the victim of their own success, he adds. "Economies have been growing rapidly, raising concerns about inflation and higher interest rates. Some investors think there might be corrections in currencies, which have appreciated."
After this correction, is Latin America a good buy now? "Long term, the region is well positioned," Kutas says. "It has a growing young, urban population." Landers agrees: "The region has strong demographics and growing employment opportunities. Banks are sound, with strong balance sheets," he says.
Perhaps most important, investors' perceptions of Latin America have generally lagged reality, managers say. "Some people see small, illiquid markets there," Kutas says. "When they think of places like Colombia, they may think of drug lords. Latin America is more like Texas during the oil boom years of the 1920s. Throughout Latin America, you can find world-class companies and improving corporate governance."
Anderson believes Latin America offers an investment play on global growth. "Beyond Brazil, Chile is a leader in copper and Peru is a major source of silver. Agricultural commodities are exported by many countries in the region," and China is a huge buyer. "Investing in Latin American stocks may be the best way to benefit from China's insatiable demand for natural resources and participate in growth in Asia."
Clients may not need to divert current holdings to gain exposure. Morningstar analyst Karin Anderson says planners should see what stocks clients already own in emerging market or core funds. "A typical diversified emerging markets fund has a 22% allocation to Latin America, including 15% in Brazil," she says.
She is wary of committing new capital. "Latin American mutual funds are very expensive, on average," she says. "Latin American ETFs are less expensive, but still more expensive than many other ETFs." Nonetheless, "if you feel comfortable with management and with a fund's fees," she says, "this could be a good time to buy."
Some advisors are also anxious, preferring to get their Latin exposure from broader emerging markets funds. "It's important to have Latin American equities in client portfolios, but not in a standalone holding," says Mark Balasa, co-CEO of Balasa Dinverno Foltz, a wealth management firm in Itasca, Ill. "We use DFA Emerging Markets Core to meet our market-cap weighting."
"We allocate to general emerging market funds and let the manager decide what should go to specific geographic regions," adds Glenn Frank, director of investment tax strategy at Lexington Wealth Management in Lexington, Mass. "One fund we use is Acadian Emerging Markets, which has over 20% of its assets in Latin America."
He uses iShares MSCI Brazil Index ETF and Claymore/BNY Mellon Frontier Markets ETF for his own portfolio. "I like the investment prospects of Brazil, and I think frontier markets offer good valuations. This frontier markets fund has substantial exposure to Latin American countries such as Chile and Colombia."
While Brazil is a leading emerging market, a frontier fund may offer more exposure to other Latin American countries. "I use my own portfolio as a test case. If I'm pleased with the Brazil and frontier markets ETFs, I might suggest them to other members of our investment committee, and they could be in client portfolios some day," Frank says.
FOLLOW THE MONEY
Planners who would like to add to or place a helping of Latin American stocks in clients' portfolios have a few big options to consider. Four offerings - Fidelity, T. Rowe Price, BlackRock and DWS - account for virtually all of the assets. There are also 21 ETFs offering exposure to Latin America, including 18 launched since March 2007. The three oldest and largest are the iShares entries tracking indexes in Brazil, Latin America and Mexico. The overwhelming majority of investments in this category are based in Brazil (62%) and Mexico (11%).
Only a few Latin American ETFs are diversified across the region, including a small-cap ETF from Market Vectors. Country funds predominate: investors can focus on Argentina, Chile, Colombia and Peru, as well as Brazil and Mexico. There's also a subregional Andean ETF from Global X that mainly invests in Chile, Colombia and Peru. Among the nine different ETFs specializing in Brazilian equities are niche products covering consumer stocks, financials, infrastructure, mid-caps and small-caps.
Rounding out the lineup of Latin American equity investments are the oldest ones: five closed-end funds dating to the launch of Aberdeen Chile Fund in 1989. Other closed-ends include two Mexican funds and two diversified regional funds.
While the funds with 10-year records all show strong performance in the last decade, performance varies widely in more recent periods. Looking at three-year trailing records from September 2008 to September 2011, which includes the 2008-09 crash and subsequent recovery, the big winners were the iShares Chile ETF (up 15.9% per year during that period) and the Aberdeen Chile closed-end fund (up 13.6%). While Chilean funds have set the pace, two leveraged offerings - Direxion Monthly Latin America Bull 2X (down 23.5% a year in the trailing three years) and ProFunds Ultra Latin America (down 20%) - demonstrated the risk.
Fortunately, unleveraged exposure to the region has been more than ample over the past decade. Planners with clients who can live with volatility might want to look south of the border.
Donald Jay Korn is a contributing writer at Financial Planning. His latest novel, In for a Pounding, is available on Kindle and Nook.