Investors like emerging markets because they offer easy GARP, growth at a reasonable price. Often, as in the case of Russia, political uncertainty provides for low earnings multiples, but positive macroeconomic trends allow for better than average growth.
Obtaining GARP, then, should be an easy process. Find the right area, drop your cash, and sit and wait. That kind of strategy has become more popular in the past decade, with emerging market funds and exchange-traded funds offering a one stop shop for exposure to the emerging markets. However, to afford this convenience, investors are giving up realistic exposure.
Investors pile into these funds thinking the fund is representative of the whole emerging nation, when it is, in fact, a play only on a few poorly weighted securities. These poorly weighted securities may not offer any real benefit in exposure to macroeconomic trends and emerging world success, but instead to industries and opportunities found (less expensively) in the developed world.
Brazil Has GARP
Brazil has been the definition of growth at a reasonable price. Its inflation is reasonable for an emerging market, growth coming out of the worst financial crisis in recent memory is reaching for 7% annually, and the government coffers are strong, as its taxes are the highest of the emerging markets. (High tax rates are a Keynesian tool for price stability and aid in soaking up hot investment money.)
With those fundamentals in play, Brazil ETFs and funds should be an excellent opportunity for foreign investment, right? Wrong! The most popular Brazil ETF and one of the largest ETFs on the market, the iShares Brazil ETF(EWZ), is perhaps the worst way to attack Brazilian growth. Nearly 75% (74.86%) of all the cash invested in EWZ is divided equally among three sectors: Industrial Materials, Financial Services, and Energy at 26.28, 24.70, and 23.78 percent respectively.
It doesn’t take much thought to realize the problem: all of the top holdings have exposure to markets that can be found in the developed world. Metal and energy prices are set worldwide on the New York, Tokyo, and London Exchanges, and financial services are dependent mostly on international growth. You could make the case that financials are directly connected to local markets, and they are, but banking profits in Brazil are (in normal market conditions) not much different than any other location.
If you absolutely have to use an exchange-traded fund to access foreign markets, seek better targeting with an exchange-traded fund that picks the best part of each market. Emerging markets aren’t exciting because they have the same old economic fundamentals or industries as other countries; they’re exciting because the consumer class is developing.
A newly formed exchange-traded fund, the Brazilian Consumer ETF (BRAQ), offers much better exposure to the growth opportunity in Brazil. First and foremost, it weights consumer goods and services at 51% of the total fund, and it maintains less than 10% exposure to metals. Also improved are the exposure levels to media and healthcare services.
Finally, BRAQ takes the cake for being balanced in asset class with 31% large caps, 41% medium sized companies, and nearly 16% in small and micro cap stocks. With sector and geographic investing exploding, investors have fallen into the trap of buying a name, not an investment. Going forward, seek first the weighting, then the fund. Unfortunately, as in the case of EWZ, investors are buying expensive exposure to metals, energy, and financials that is hardly representative of the underlying Brazilian economy. Such investments are destined to under-perform when the true emerging market, the consumer market, finally shows its strength.