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The Brazilian equity market has been in a rough patch recently. Investor unfriendly government policy coupled with the global economy's fitful recovery has led to disappointing returns for the country's two largest ETFs.

Three year chart:

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Does it make sense to get back into Brazil and do ETFs make sense given the equity market's structure and what we know about government policy risks? The answers are not all encouraging.

Market structure is skewed toward cyclical and policy risk companies

The structure of Brazil's equity market is weighted heavily in favor of companies that face risks relating to global cyclical demand or government policy intervention, or both. Sectors like financials, energy, materials and utilities - which represent around 67% of the investable universe according to MSCI - all face state policy intervention risks that promote social objectives over shareholder interests.

Brazil ETFs

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Look deeper

iShares MSCI Brazil Capped (NYSEARCA:EWZ) is the third largest emerging market equity ETF after Vanguards FTSE Emerging Markets (NYSEARCA:VWO) and iShares MSCI Emerging Markets (NYSEARCA:EEM). EWZ has around 80 holdings and many of its top holdings are well known large cap companies listed in the US; Petrobras (NYSE:PBR), Vale (NYSE:VALE), Itau Bank (NYSE:ITUB), Banco Bradesco (NYSE:BBD), Ambev (ABV) and Brasil Foods (NYSE:BRFS). The fund's sector exposure is mostly in financials (28%), materials, consumer staples and energy.

EWZ is concentrated

EWZ follows the MSCI capped index, which is a methodology designed to limit any single issuer to a 25% weight in the fund and limit the sum of all issuers representing more than 5% of the fund to not exceed 50% of the fund's total assets. This is to protect the fund from being too concentrated in a few holdings. EWZ's top 5 holdings currently represent 44% of the portfolio so it is not in breach of the methodology but still concentrated.

Market Vectors Brazil Small Cap (NYSEARCA:BRF) is a fairly broad fund holding over 70 companies below $5bn market cap. BRF has large exposure to consumer discretionary stocks (39%), industrials and financials. For some color, a look at the top 10 holdings shows three private higher education schools, two real estate developers, an insurer, a utility, a medical diagnostics company, a port logistics operator and a construction company.

iShares MSCI Brazil Small Cap is another small-cap option. EWZS tracks the MSCI index and is comprised of the bottom 14%, by market cap, of listed companies in the index. The fund also has large consumer discretionary, industrials and financials exposure like BRF yet has performed better.

EGShares Brazil Infrastructure (NYSEARCA:BRXX) is a fund with heavy utilities and telecoms exposure (46% total) as well as holdings in industrials, real estate and materials-related companies. It is a more concentrated portfolio with 30 holdings. The fund has faced headwinds as a result of government initiatives to control utility prices.

Global X Brazil Consumer (NYSEARCA:BRAQ) follows the Solactive Brazil Consumer index and offers investors exposure to the food & beverage, retail, personal goods, travel and leisure sectors. The average market cap of the portfolio is over $8bn and it is a concentrated fund with around 25 holdings. It has been the best performing ETF recently.

EWZ dominates the market

EWZ is a giant of the ETF universe trading over $800m/day. BRF trades around $6.5m/day, EWZS and BRXX trade closer to $0.5m/day, and BRAQ trades around $100k/day.

Performance has varied

Two year chart:

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Overall the Brazilian market represented by EWZ has underperformed the benchmark EEM. BRF has also been a laggard while EWZS and BRAQ have performed well.

Watch out for realized capital gains

The underperformance of BRF is partly due to a sizeable ($3.82/share) realized capital gain in 2011. The fund redeems and creates its creation units in exchange for cash, rather than in-kind securities, so cannot always eliminate capital gains like a traditional ETF. This cash transaction risk is a negative feature of Brazilian ETFs and a potential drag on returns.

Changing policies?

The Brazilian government exercises significant influence over sectors like energy, utilities and banking. Recent policies to regulate (suppress) domestic energy prices and bank spreads have negatively affected several large listed companies.

Confidence is low, yet there have been some indications market friendly policies may ensue. A domestic diesel fuel hike was announced in early March. Pressure on banks to lower rates and push lending has been reduced. Conditions have improved for infrastructure concessions to private operators. Whether these measures constitute a structural change in Brazil's policy-making remains to be seen, but at least the rain has stopped.

Macro is still weak

Another fundamental question for investors relates to global growth and Brazil's macroeconomic outlook. Brazil is a major exporter of basic commodities like iron ore, crude oil, soybeans, sugar and engineered products like autos and aviation craft. Global demand growth is crucial for the economy.

GDP growth in 2012 was a pedestrian 2% and expectations coming into this year were for a pick up to 4%, although that's starting to look optimistic. Inflation has also negatively surprised to the upside with February data showing 0.6% month-on-month growth despite cuts in electricity rates.

This does not bode well for near-term interest rate cuts. Nor does the prospect for a weaker currency - the BRL has already strengthened by 4% versus the USD since the start of the year and the dollar has been strong this year relative to many other currencies.

There is potential

Brazil has great promise as a young growing country. According to US Census data, more than 50% of Brazil's population is 30 years old or younger. This will be an important long term driver since 30+ year olds work, save, spend and invest. They also borrow money for things like cars, homes and other durable goods. This powerful economic growth driver is well in place. The country also has a series of international events like the soccer World Cup in 2014 and Summer Olympics in 2016 that will require investment and should be a boost for the economy.

Be selective

Structurally EWZ is challenged. It is concentrated in a few large companies exposed to government policy and global cyclical risk. Yields do not suggest much value either.

There are companies that are doing fairly well in Brazil. Targeted funds like BRAQ and EWZS have shown better returns in a tough climate with portfolios that have avoided direct policy and cyclical risks. Portfolio execution matters too.

Brazil offers opportunities - consider what you are buying.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Brazil ETFs: Not Making Sense