This week’s Barron’s has a special section on investing in Brazil. It included an article featuring a panel discussion with three investment managers who have an interest in Brazil.
One of them, Christopher Abuthnot, Senior Portfolio Manager at John Hancock Asset Management, addressed a question on Brazil’s largest cap companies – Petrobras (NYSE:PBR) and Vale (NYSE:VALE) for example – that represent large segments of Brazil’s Bovespa:
So the companies that dominate the Bovespa, which are also the firms that trade in the U.S., are not the best opportunities to get at Brazil's growth?
Arbuthnot: Right. Less-sophisticated investors may buy the big benchmark names, like Petrobras and Vale, and they're great companies. But we don't own them. If you can buy locally-listed stocks, you'll find better risk/reward profiles in the lesser-known benchmark names, which still have substantial market share and phenomenal management teams.
I tend to agree. If you take a look at one of the mostly widely traded Brazil ETFs, the iShares MSCI Brazil Index Fund (NYSEARCA:EWZ), you’ll see that various classes of shares of Petrobras and Vale – along with Itau Unibanco (NYSE:ITUB) and Banco Badesco (NYSE:BBD) account for nearly 47% of the entire ETF.
As Arbuthnot notes, Petrobras and Vale may be great companies (and I own Vale), but as the country’s middle class continues to grow, companies that meet expanding domestic demand will probably do quite well.
That’s one reason why I happen to own another ETF, the Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF). This fund owns some of the smaller companies that appear more leveraged to growth within the country and less leveraged to exports.
A look at the sector allocation between the two funds shows a big difference in the types of companies in these ETFs.
Taking a look at performance year-to-date, both BRF and EWZ are down, with BRF underperforming the larger-cap EWZ fund by around 4.3.
But looking over the past two years or so, BRF has outperformed EWZ, especially in late 2010 into early 2011.
High beta vs. Brazilian Real
If you plot weekly price changes for BRF against weekly price changes in the SPY ETF, you can see that there’s a positive relationship between the two. The slope of the linear regression line essentially represents the fund’s beta to the SPY ETF.
But there’s an even stronger relationship between the BRF ETF and the Brazilian Real as you can see here – a higher beta and higher correlation.
Any country ETF is going to be subject to currency risk. And given the recent strength in the U.S. dollar with respect to the Brazilian Real, it’s not surprising that BRF has given up a lot of its gains this year.
A better small-cap Brazil ETF?
There’s another small-cap Brazil ETF, the iShares Small-Cap MSCI Brazil Small Cap Index Fund (NYSEARCA:EWZS). It has only been trading for a little over a year now, but it seems to outperform the Market Vectors BRF ETF.
Why? I can’t say for sure, but I did take a look at the top 15 holdings for both BRF and EWZS.
As you can see in these tables, while BRF does include many of the companies in the EWZS top holdings, EWZS does not seem to own companies that top the BRF list. It's what EWZS doesn't hold that could be what adds more lift to its performance.
(Note that symbols with numbers at the end represent shares traded in Sao Paulo, but that two of BRF’s holdings are actually U.S. ADRs.)
I also took a look at the sector allocations for both funds – comparing the large-cap EWZ with both BRF and EWZS.
As you can see, EWZS adds more financial and industrial exposure than BRF and tends to underweight the materials sector.
EWZS is a fairly small fund, only $47 million in AUM with an average daily volume over the past three months of about 19,000 shares. BRF is more than 10 times as large at $636 million with an average share volume of 244,000 shares.
As I mentioned, I own Vale, but I do want to continue to own these Brazilian small cap companies. If I put new money to work however, I might consider EWZS instead of BRF – especially if EWZS gains more traction and greater liquidity.
Disclosure: I am long BRF, VALE.