ETF investors are increasingly looking at Latin America for investment as these emerging market countries have rebounded more quickly from the economic crisis, as Emma Dunkley reports
The Brazilian stock market significantly rebounded since March, following a huge sell off in Brazilian stocks last year as commodities plummeted. The main index has grown 30% year to date, representing one of the best performing stock markets in the world at present. The resurgence of the Brazilian market has made investment in ETFs based on Latin America an increasingly lucrative proposition this year.
“ETFs based on Latin American indices are very popular – you can see from the issuers that there is huge competition,” said UniCredit head of ETF trading and advisory Paolo Giulianini. “These are also some of the most traded ETFs among investors because the Brazilian indices are more popular now than Russia, India and China within Bric, and there is a lot of growth opportunity within Brazil still.”
“In general, as the emerging countries have been less affected by the economic crisis, this has benefited certain indices and therefore the performance of the ETFs” Paloma Piqueras, BBVA Asset Management
ETFs tracking indices based on Brazil have delivered the best daily total returns in the last three and six-month time periods compared with other Latin American underlyings, according to data from Morningstar. For example, the top seven performing ETFs over the three-month period have all been based on indices comprising Brazilian stocks, with the Acción FTSE Latibex Brasil ETF performing best at 28.58%.
However, in terms of one-year total returns, the best performing ETFs were based on Chilean and broader Latin American MSCI indices. Giulianini explained that the better short-term performance of Brazilian-based ETFs reflects the rally of commodities and oil since March. He added that oil more than doubled from $30 to $35 a barrel to $70 to $73 in this time period, which had a large impact on Brazil.
In the broader sense, the MSCI EM Latin America index increased by 46.5% YTD as of May in US dollars terms, according to the June ETF Landscape Review by Barclays Global Investors.
Yet with all indices, investors need to be aware of changes to the underlying constituents and their weightings. Guilianini highlights that Argentina has been downgraded this year by MSCI indices and is out of the MSCI Latin America index which underlies ETFs. As a result, this index comprises five countries: Brazil, Chile, Mexico, Columbia and Peru.
The issue of foreign-exchange risk should also be taken into account as each index constituent has a different currency. For example, the underlying stocks of a European-listed ETF are bought in different currencies, such as the Brazilian real or Mexican peso, which means that the underlying stocks as well as the currencies have to be hedged, said Giulianini.
He explained that in order to mitigate foreign-exchange risk when trading a currency such as the Brazilian real, a non-deliverable forward (NDF) can be used on the currency. However NDFs entail interest-rate risk, as the forward currency is being bought as opposed to the spot currency, allowing for changes in interest rates. “We take into account the NDF price when we create the price of the ETF, by using the spot rate that we derive from the forward rate on Brazil, for example,” said Giulianini.
He added that while investors can trade London-listed ETFs before the Latin American market opens in the morning, the market for the underlying securities is most liquid in the afternoon for London-based ETFs, given the time difference.
As certain Latin American-based indices are euro-denominated, European investors do not have to deal with the local currencies, although they are still assuming forex risk, explained Paloma Piqueras, global product development managing director at BBVA Asset Management. She said that the FTSE Latibex Brasil is the only euro-denominated tradable index covering Brazil for European and Latin American investors, as Latibex comprises the 13 most liquid Latin American securities on Spanish exchanges.
The weightings of each component are determined by free-float adjusted market capitalisation. As a result, the basic resources sector has the highest weighting at 40%, while oil and gas, and the banking sector are weighted at around 20% each, said Piqueras. “The commodity prices have pushed up the performance of the Latin American market and the Latibex index,” she added.
While BBVA’s Acción FTSE Latibex Brasil ETF gained the best total three-month returns, reflecting the upturn in the Brazilian market over this period, Lyxor’s ETF Brazil was the top performing over six month with returns of 53.07%. “In general, as the emerging countries have been less affected by the economic crisis, this has benefited certain indices and therefore the performance of the ETFs,” said Piqueras.
She added that BBVA is looking to develop more ETFs based on Latin American underlyings and is considering Mexico. “However, this depends on the development of the local market – as these markets become more highly developed, for example, in terms of regulation and market liquidity, we will try to cover the region,” she said. “Our strategy is to develop our offering based on Latin America.”
The db x-trackers MSCI Brazil was one of the better performing ETFs in terms of six-month returns, at 48.03%, although the broader db x-trackers MSCI EM LatAm ETF produced better one-year returns than the Brazil fund, at -20.04%. “Since the beginning of this year, we’ve seen increased uptake of emerging market ETFs, with inflows of assets especially coming through on our Latin America ETFs,” said db x-trackers head of UK Manooj Mistry.
He explained that assets in the db x-trackers MSCI EM LatAm ETF have almost quadrupled, from $55m at the end of December to $200m as of July. “Brazil has tripled in size since the beginning of this year, showing that investors are coming back into the emerging markets,” added Mistry.
He explained that swap-based replication is advantageous in terms of gaining exposure to certain countries in Latin America where the underlying stock markets are not very liquid, such as Columbia. He said that the construction of most indices is based on market capitalisation as opposed to levels of liquidity, trading volumes, or whether there are constraints in terms of buying particular stocks. “When you try to replicate an index like this through full replication, there are potential problems, especially where you can’t access stocks. Synthetic replication means the performance is delivered through a swap, which ensures the ETF will track the index perfectly, with the exception of the all-in-fee or total expense ratio,” he said.
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