Brazil ETF Investing: Five Critical Factors To Consider

by on February 29, 2012 | Updated July 18, 2012 | ETFs Mentioned:

As interest in emerging markets has accelerated over the past few years, many investors have sought to identify the economies from the developing world that maintain the most significant long-term potential. Many engaging in that search have gravitated towards Brazil, home to an abundance of natural resources, a successful clean energy revolution, and an economy that maintains strong ties with the Asian powerhouses that have become major drivers of GDP growth. And it should come as no surprise that ETFs have emerged as a popular tool for gaining exposure to the Brazilian stock market; the flexibility and tax efficiency of the exchange-traded structure make ETFs a perfect way for tapping into promising emerging markets.

There are currently about nine different ETFs offering exposure to the Brazilian economy. While there is meaningful overlap between some of these products, Brazil ETFs are far from identical; each maintains unique risk/return profiles. Below, we highlight five factors that any investors considering a position in Brazil should consider; your viewpoints on these five topics should help to narrow down the lineup of Brazil ETFs to one that is consistent with your objectives [see the LatAm Centric ETFdb Portfolio]: 

1. Large Cap Vs. Small Cap

As with many international markets, U.S. investors now have the option of choosing between Brazil ETFs that focus on large cap and small cap stocks. There are, of course, potential advantages and drawbacks to both. While large cap ETFs deliver more efficient exposure to a swath of companies that is representative of the underlying economy, many view small cap ETFs are a better “pure play” on the Brazilian economy. That is, whereas the large cap companies tend to derive their revenues from various markets throughout Latin America and around the world, smaller Brazilian companies count more directly on local consumption to drive revenue and profitability [see Guide To Small Cap International ETFs].

As detailed below, there are additional differences in the portfolio that can result from the small cap vs. large cap decision, including sector and other biases. For investors looking to gain exposure to the biggest of the publicly-traded Brazilian companies, the iShares MSCI Brazil Index Fund (EWZ) is by far the most popular option; that ETF consists almost entirely of mega cap and large cap stocks. Those looking to focus on smaller companies might prefer the MSCI Brazil Small Cap Index Fund (EWZS) or the Market Vectors Brazil Small Cap Index ETF (BRF).

2. State Owned ETF?

When the U.S. government stepped in to bail out some auto companies and financial institutions during the recent recession, it was seen as a significant deviation from the normal course of operations. But in many international markets, it is not the least bit uncommon for the government to hold a significant ownership stakes in various companies. That is the case in Brazil, where the government is one of the largest shareholders in a wide range of entities–including many of the components of popular Brazil ETFs [see Brazil ETFs: Best Of The BRIC].

The presence of state-owned companies can be a bit problematic for several reasons. When the government can influence decisions made by a company (or control them outright), there exists the potential for the company to act in ways that are not most beneficial for shareholders. Oil companies may sell off reserves in order to generate revenue to fund other government programs, or mining firms may sell at less-than-optimal prices to boost the companies that purchase raw materials. These outcomes are by no means guaranteed, but are certainly possibilities when the government has a significant ownership stake in any entity.

While the presence of state ownership isn’t ever kept a secret, there’s no easy way to determine how significant the ownership of the government is in an ETF. It requires a bit of manual research into the individual holdings, which can obviously be a time consuming process. Generally, large cap ETFs such as EWZ will tend to have higher allocations to state-owned companies; small cap ETFs will generally have smaller weightings afforded to stocks that are partially owned by the government.

3. Sector Biases

It is relatively common for international ETFs to maintain biases towards certain sectors of the economy. Because these products tend to include the largest companies in their economy, they commonly include biases towards the sectors that maintain disproportionately high allocations to big companies–which generally includes banks and oil companies [try the Free ETF Head-To-Head Comparison Tool].

In the case of Brazil, there are some pretty hefty allocations made to the materials, financials, and energy sectors; these three segments combine to make up more than 65% of the portfolio. At the opposite end of the spectrum, EWZ makes very little allocation to health care stocks (less than 1% of the portfolio) and has less than 5% of holdings in consumer discretionary companies. Considering that a significant driver of the Brazilian market is expected to be surging consumer spending related to a rising middle class, the underweight position in the consumer segment might be less-than-optimal.

In this regard, ETFs such as the Brazil Consumer ETF (BRAQ) might be useful tools for altering the sector balance maintained by more “broad-based” funds such as EWZ.

4. Currency Exposure

When investors establish a position in Brazil, few have a well researched opinion on the direction of the Brazilian real. Most Brazil ETFs include exposure to the currency of the South American country, whether they realize it or not. Because the underlying securities are priced in the local currency, fluctuations in the value of that currency relative to the U.S. dollar impact the returns realized by U.S.-based investors. If the Brazilian currency strengthens, it can give a boost to Brazil ETFs traded in the U.S., and vice versa. And while it might sound like a minor detail, the impact of currency movements can be significant in both the short term and long run [see For ETF Investors, Currency Exposure Matters].

The currency of Brazil, a commodity-rich emerging market, has the potential to exhibit significant volatility in certain environments. And those fluctuations have a major impact on the  bottom line returns experienced by ETFs that offer exposure to Brazilian equities–at least to the majority of them. For investors looking to strip out the exchange rate components from a position in Brazilian stocks, there is one ETF that allows for isolation of the equity returns. The Deutsche Bank MSCI Brazil Currency Hedged Equity Fund (DBBR) is linked to an index that is substantially identical to EWZ but utilizes currency forward contracts to strip out the exchange rate impact on performance. The result is a portfolio that is indifferent to exchange rate fluctuations, and instead measures only the performance of Brazilian equities.

For investors who don’t want to worry about currency risk and would prefer simply to bet on Brazilian equities, DBBR might be worth a closer look.

5. Special Tax Considerations

Brazil is a bit unique in that there are special tax considerations that can impact the returns realized by U.S.-based investors. In December of 2011 the Brazilian government eliminated a 2% tax on foreign equity investors, a levy that was reportedly put in place initially to protect Brazil from the global debt crisis. When the tax was initially installed, it obviously had an adverse impact on ETFs that offer exposure to Brazilian stocks, and caused these products to consistently trade at a premium to their NAV [see ETF Tax Tutorial].

The removal of the tax, which was implemented in an effort to curb speculative bets on Brazilian securities by high frequency traders, resulted in a one time spike in the value of assets denominated in the Brazilian real. It’s worth considering that there is a possibility of future taxes on foreign investments in Brazil; U.S. investors should be aware that this scenario exists, and that it could deal an unexpected blow to Brazil ETFs in the future.

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Disclosure: No positions at time of writing.