iShares Brazil Still Offers Rewards, but with Increasing Risks

 |  Includes: BBD, EWZ, GGB, ITU, PBR, SID, UBB, VALE
by: Don Dion

With a five-year annualized return of 55.6%, iShares MSCI Brazil (NYSEARCA:EWZ) has been the best-performing ETF tracked by Morningstar. The fund is also tops over three years (also 55.6%) and 14th among all ETFs, with a one-year return of 47.7%.

But EWZ stumbled over the last month, falling 11.3% (through June 20) to an eight-week low, thanks to a sell-off driven by concerns over global inflation and a potential dip in China’s demand for the commodities that drive Brazil’s economic engine (chart courtesy of - click to enlarge).

The country’s benchmark market index, the Bovespa, is down 11% after posting a 186% gain from April 2005 to this month and a 500% increase in five years. Neither the index nor EWZ has fallen like China’s Shanghai Composite, which is off 50% from its October 2007 high.

EWZ’s run-up has—of course—been driven by the commodities boom. The economy of Latin America’s largest country is dominated by energy and materials, putting Brazil in the stock market’s sweet spot of recent years.

But Brazil has also shown strong economic growth, pushed by a booming middle class that’s helped the country’s economy grow. Inflation remains relatively low (by South American standards), and Brazil’s currency, the real, has rallied. Finally, in April and May, first S&P and then Fitch Ratings raised the nation's sovereign debt to investment-grade status, a sign of maturity, continued recovery and a decrease in the country’s debt.

All that, combined with a year-to-date return of 10.4% that places EWZ second among all iShares funds, has some investors banking on the fund for long-term success.

We added EWZ to our ETF Momentum Tracker International Portfolio on May 2, 2007. Since then, the ETF’s NAV is up 66.3% through June 20. EWZ has held the top spot in our momentum rankings since February.

Of the BRIC (Brazil, Russia, India and China) countries with the hottest markets of recent years, bulls point to Brazil and Russia as economies that produce and sell the commodities that the world’s other rapid-growth stories need. And Brazil’s resources are more diversified.

EWZ, the only pure-play Brazil ETF, is certainly a play on the country’s commodity stockpile. Taking different share classes into account, its top two holdings, Petrobras (NYSE:PBR) and Cia Vale do Rio Doce (NYSE:RIO) (also known as Vale), make up more than 45% of the portfolio.

Diversified oil giant Petrobras, which is bigger than BP (NYSE:BP), Shell (NYSE:RDS.A) and Total (NYSE:TOT), recently announced the discovery of the massive Tupi oil field off the coast of Rio de Janeiro. It has seen shares more than double in the last year and 14.2% year to date. The company plans to double its output by 2015.

Vale, the world’s second-largest mining company and the top provider of iron ore, has risen in price by 65%. Vale has been on a buying spree while predicting that China will soon account for 55% of global iron ore consumption, buying up Canada’s Inco for $17 billion and nearly acquiring Swiss-based Xstrata for $90 billion earlier this year. Shares are up 53.6% over the last year, 6.2% YTD.

Of course, not everyone is a Brazilian bull. The country’s stocks get hurt when investors pull away from risk, as they did in recent weeks. At the end of May, the Bovespa’s average valuation hit 16.8 times earnings, 61% higher than three years ago, according to Bloomberg. Deutsche Bank AG cut its ratings on Brazilian shares to neutral on May 21, citing the same concerns that have hurt EWZ of late: higher interest rates and a potential slowdown in China.

Bull or bear, it’s important to consider the fund’s risk and volatility. With a three-year standard deviation of 30.06, EWZ is, by that measure, the second-most volatile ETF in the Morningstar universe—behind only iShares FTSE/Xinhua China 25 Index.

The reasons are many: First, Brazil is truly an emerging market, a country that teetered on the verge of bankruptcy in 2002. Second, the economy is tied to commodity prices, and so is the fund, with nearly 60% of assets in mining or energy stocks. Finally, while the fund holds 79 stocks and has grown to nearly $10 billion in total assets, it remains heavily focused on a few key stocks.

This month’s dip wasn’t the first for EWZ and likely won’t be the last. But pullbacks from risk and profit-taking sell-offs are a fact of life here. The bigger question is, what happens to EWZ if there is a slowdown in China or a global recession.

Bottom line, EWZ has a lot going for it in addition to those world-beating returns. But that run-up—and the risk that comes with it—means that the ETF should play a limited role in the portfolio of investors with the stomach to handle its gyrations.