Latin America Funds Poised To Outperform

by: Emerging Money

By Joseph Hogue, CFA

With the hefty market disturbances over the last three months and the likelihood of problems over at least the next quarter or two, now might be a good time to review the performance of regional and country funds and reallocate where needed.

Latin America has held up slightly better than some of the other emerging regions, largely due to its healthy growth in domestic consumption and relatively higher reliance on Asia and the U.S.for export sales. Most of the countries in the region are still registering strong GDP growth and inflation is close to or within the central banks' targets.

The iShares S&P Latin America 40 (NYSEARCA:ILF) has underperformed the iShares MSCI Emerging Markets Fund (NYSEARCA:EEM) over the course of 2012 due to its overweighting (54.2%) of Brazil while the Global X FTSE Andean 40 (NYSEARCA:AND) has beaten both with returns of 6.3% over the same period.

The iShares S&P Latin America fund has lost 9.5% since the beginning of the year compared to a 13.7% loss in the iShares MSCI Brazil (NYSEARCA:EWZ). The Global X FTSE Colombia 20 (NYSEARCA:GXG) has had a stellar run with a return of 14.9%, well above Andean partner funds like the iShares MSCI Chile (BATS:ECH) and the iShares MSCI All Peru (NYSEARCA:EPU) with gains of 1.6% and 4.4% over the same period.

The Andean region (Chile, Colombia, Peru) continues to be the standout with the three country funds the only winners so far this year. Chile is still the most closely correlated with copper prices and will probably underperform until global growth picks up.

There are worries that credit growth is overheating, especially in Colombia, but we're still well off from a bubble environment. Colombia should continue to do well as it aggressively signs free trade agreements and attracts foreign investment. While Colombia's economic progress should remain intact, the 14.9% gain in its country fund does not offer the best value.

Peru's market is still relatively small and stands to gain the most from market integration. The best bet is probably still a diversified play on the region with the Andean fund.

Brazil may rebound in the first half from recent economic weakness, but policy risks remain a worry for investors. The government has intervened aggressively in the foreign exchange markets pushing the real to the weakest level since 2009 and making it the worst performing currency tracked by Bloomberg.

Appearances of integration and political pressure between the central bank and the government have raised questions of central bank independence and weakened the country's economic stability. While the country fund will most certainly rebound over the long-term, headline risk from government intervention means that short-term risk adjusted returns will be below peers.

Even Mexico, with its strong export growth and relatively stable economy has seen losses in its benchmark country fund. The iShares MSCI Mexico Investable Fund (NYSEARCA:EWW) has lost around 0.7% of its value since the beginning of the year, but is off 12.0% from its highs earlier this month. Despite higher than normal unemployment, the country benefits from a strong domestic demand and economic growth in theUnited States. Core inflation is down around 3.5% and rates are still high enough to give the monetary authorities room to ease. While the country fund will probably not outperform the Andean countries over the rest of the year, volatility is low and it acts as a good diversifier to a Latin American portfolio.

In last place with a government-induced disappointment is the Global X FTSE Argentina 20 (NYSEARCA:ARGT) with losses of 28.1% since the beginning of the year. The country is still facing a difficult economic reality and is shut out of the bond market for financing. Macroeconomic and political intervention have trumped corporate-level performance and will continue to do so this year. While the money on the short side may have been made, the odds are still against any kind of a rebound.

I would continue to favor the Andean region in the portfolio and avoid equities or funds with exposure to Argentina. Investment in the broader S&P Latin America Fund is largely a bet on Mexico and Brazil with some marginal exposure to other countries. Mexico may do well, but significant risks remain in Brazil, so I would avoid the fund and go directly with the Mexican country fund.

Further losses to global equity markets are likely over the next few months as the crisis in Europe works its way out. Investors may want to take a short position in larger global funds that can help mitigate losses in Latin America exposure. Once global risks subside, these regional and country funds should rebound quickly and outperform developed market funds.