Population dynamics and austerity measures in the developed world naturally compel a rebalancing toward emerging markets, and within the space, Latin America stands out as a solid bet.
Latin America — and the emerging markets in general — rebounded surprisingly quickly from the recession in 2008. From the market lows in March 2009 to the highs of this year, the iShares MSCI Emerging Market ETF (EEM, quote) and the iShares S&P Latin America 40 (ILF, quote) gained 50.7% and 51.2% respectively on an annualized basis against a 40.1% annual gain in the S&P 500 (SPY, quote).
The crisis in Europe has increased volatility in emerging markets but not to the extent that it has affected developed market indices. Volatility of returns in the S&P 500 has increased by 43% since May while volatility in the EEM and ILF has only increased 27% and 17%, respectively.
This relative outperformance and subdued risk to volatility is due to the positive fundamental growth environment in the emerging markets relative to the developed world. Global growth of about 4.3% this year will largely be driven by economic performance in the emerging world.
Consumer spending and a burgeoning middle class are driving much of the growth within these markets. According to the Economist Intelligence Unit, personal disposable income per capita in Latin America increased over 68% in the ten years to 2010 while that of U.S. consumers only increased by 13% in the same period.
Growth in same-store sales in Brazil have been averaging around 10%-12% while U.S. growth lags considerably at 1%-2% per year. Because of the consumer growth story, Latin America is less heavily dependent on exports than other emerging markets and therefore somewhat insulated from lower growth in the United States and debt problems in Europe.
Global factors still dominate equity values and returns to key sectors like energy and basic materials. Volatility in Latin American securities will continue to be high until the debt crisis in Europe is resolved. Consumers and corporations in Latin America are not as highly levered as their developed market counterparts, so the market is somewhat protected from a prolonged crisis within the credit markets.
A longer-term problem for Latin America is bringing productivity growth rates in line with that of other markets. Annual growth in productivity over the last 30 years in Latin America has averaged only 3.9%, compared to 5.8% during the same period in the United States. Productivity growth rates in the region’s exporting sectors like agriculture and basic materials is relatively stronger, but other sectors lag significantly.
Chile is the notable exception, with growth in productivity on par with that of the United States. The lack of productivity growth has important social and economic repercussions for the region. As the region globalizes, it must increase productivity to remain competitive.
Three Funds for Regional Exposure
The iShares S&P Latin America 40 (ILF, quote) is the most heavily traded ETF for Latin exposure with about 2 million shares traded daily. Despite its claim of providing exposure across Latin America, it is heavily concentrated in the stocks of two countries: Brazil (54.2%) and Mexico (26.9%) with marginal exposure to Chile (11.0%), Peru (4.8%) and Colombia (2.3).
For this reason, I would generally recommend combining it with another fund or a selection of the country-specific funds covering the region. This will diversify exposure a little more evenly and can allow investors to target countries of choice. The fund is spread more evenly across sectors but still slightly overweight financials (22.0%) and materials (20.0%), even considering the region’s overweight exposure to these industries.
Since the market highs set in May, the fund has lost 17.7%, bringing its price-to-earnings ratio to 11. As with many indices and the funds based on them, stock representation is based on size and liquidity, and not necessarily on an outlook for appreciation. The fund can provide for good passive exposure to the region, but investors will need to selectively invest in individual countries or companies to enhance returns.
The Market Vectors Latin America Small-Cap (LATM, quote) provides exposure to small-cap companies within the region, which generally have higher growth rates than their larger counterparts. The fund includes companies that generate at least 50% of their revenue from the region and have a market capitalization of at least $150 million.
Companies must be within the bottom 90% to 98% of the market in terms of size and have a monthly trading volume of at least 250,000 shares. This kind of rules-based strategy to index inclusion presents opportunities for investors to accumulate shares of companies ahead of the index — a legal form of front-running, but beyond the scope of the article.
Because of the rules-based revenue inclusion, the fund includes companies headquartered in Canada (21.0%), the U.S. (4.1%) and Australia (1.1%). Latin exposure consists of Brazil (40.4%), Mexico (18.0%) and Chile (12.3%) with marginal exposure to Argentina, Puerto Rico and Panama.
Chile, Colombia and Peru have been getting a lot of attention in the capital markets lately as the integration of their equities trading develops. The Latin American Integrated Markets (MILA) was the subject of a one-day Bloomberg conference at which I spoke in September. Though global events have taken back much of the limelight, Mexico and Panama have recently shown their interest in joining the integration.
The Global X FTSE Andean 40 (AND, quote) has been created to take advantage of the integrated markets. The Andean fund holds the 40 most liquid equities in Chile, Colombia and Peru and charges an expense ratio of 0.72%.
The fund tracks the new MILA exchange closely with country weights of 51% Chile, 33.4% Colombia and 15.5% Peru. Sector exposure also mimics the integrated exchange — although with some tracking risk — with 26.4% materials, 24.3% financials, 12.6% consumer goods, 12.4% utilities, 12.0% energy and 10.2% industrials.
Trading volume is light, but all represented shares are highly traded on their native exchanges, so liquidity is not necessarily a problem. The fund should benefit from technical support as pension funds from the three countries increase their exposure to foreign shares.
Past integrations, most notably Euronext, have shown increased liquidity and decreased trading costs, which would be another form of technical support to the shares. The combination of key sectors within each market means the fund is well-diversified. Returns from 2002-2008 show lower volatility for the stocks in the fund when compared to the Brazilian or Mexican markets as well as the iShares Latin America fund.
Investors may want to position the portion of their portfolio dedicated to Latin America through a core-satellite approach. This approach places the majority — 50% to 70% — of the allocation in a market fund then uses the rest to actively invest when opportunities arise. The long-term position in the regional funds provides a good passively managed base to profit from fundamental growth drivers.
As we’ll see from the next two articles in the series, investors can position themselves in the short term by investing in specific country funds and individual companies.
By Joseph Hogue, CFA
Disclosure: Author is long a position in (AND)