No to Latin America Funds

Five Good Reasons to Avoid Latin America Funds

These red-hot funds are too extreme for most investors.

by William Samuel Rocco | 12-20-05 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints

Hot funds always attract a lot of interest--and they always should be approached cautiously. Many readers and reporters have contacted us in recent months to ask for Latin America fund recommendations. Their interest comes as no surprise. These funds zoomed more than 60% in 2003, due to macroeconomic and corporate progress in the region as well as robust demand for commodities and strong investor interest in the developing world. They surged nearly 40% in 2004 for similar reasons. And they're up more than 50% for the year to date through Dec. 14--on pace to be the top-performing category of mutual fund for the third straight year--as conditions have remained quite favorable south of the border. Overall, Latin American funds have posted a 52% annualized three-year return, which is 18 percentage points more than the annualized three-year return of the next highest-returning mutual-fund category.

While these results are very impressive and quite alluring, we're normally wary of Latin America funds, and we're especially leery of them at this point in time. There are five reasons for our general and current skepticism; here are the details.

1) A Tiny and Unimpressive Category
There are only seven distinct offerings in the Latin America category--including two single-country ETFs--and several of them have high expenses or other weaknesses.   Scudder Latin America SLANX has experienced managers and a solid long-term record--though it has lagged in the current rally due to its conservative style--but its 1.82% expense ratio is high in absolute terms, and Scudder's market-timing issues make the family's whole lineup unattractive Merrill Lynch Latin America MDLTX has been a good performer, but it is pricey and has experienced several manager changes since 2000.   IShares Latin America S&P 40 Index ILF boasts a relatively fetching 0.50% expense ratio and strong rally returns, but its passive approach hurt in the 2002 Latin America sell-off. The fact that investors must pay brokerage commissions to buy shares means that its cost edge erodes when individuals dollar-cost average. In short, investors have very few good Latin America offerings to choose from.

2) Exceptionally Narrow Purviews
Latin America funds have always concentrated on the Brazil and Mexico markets. They've become even more focused on those two exchanges over the past decade, as the investment options have shrunk in Argentina and the opportunities in the region's other markets haven't expanded much. The typical Latin America offering now has 90% of its assets in Brazil and Mexico.These funds are very concentrated sectorwise and stockwise as well. They devote roughly 30% of their assets to industrial materials, 20% to telecom, and 15% to energy, in fact, while they provide zero to minimal exposure to software, hardware, health care, and business services. What's more, the four active offerings in the group usually hold between 50 and 70 stocks and devote between one half and two thirds of their assets to their top 10 issues, whereas iShares Latin America S&P 40 Index normally owns 40 names and invests two thirds of its assets in its 10 favorites. Consequently, these funds aren't nearly diversified enough to make good supplemental overseas offerings.

3) Extreme Volatility
Not surprisingly, given their emphasis on just two emerging markets, a handful of sectors, and a few dozen stocks, Latin America funds can really blow up when things go awry. Indeed, they've plunged 20% or more in 13 rolling three-month periods during the past 15 years, while Pacific/Asia ex-Japan offerings have fallen 20% or more in eight such periods and diversified emerging-markets funds have declined 20% or more in six such periods in the past 15 years.Meanwhile, Latin America funds have a 10-year standard deviation of 29. Only technology and precious-metals offerings have worse 10-year standard deviations, and Pacific/Asia ex-Japan funds and diversified emerging-markets funds have better 10-year standard deviations of 28 and 24, respectively. This extreme level of volatility makes Latin America funds too risky for the vast majority of investors and awfully tough to use well.

4) Unsustainable Returns
The spectacular returns these funds have produced the past three years are unsustainable over the longer run. It's virtually impossible for any type of fund to earn 40% to 60% annual returns for more than a few years in a row. One reason is that extended and exceptional hot streaks often lead to lofty price multiples, which cause many investors to shift their assets away from an area toward other markets that are more attractively valued and thus enjoy better short- to mid-term potential. This means that investors certainly should not expect the next three years to be nearly as good as the last three years for Latin America funds and that they should not be surprised if these offerings experience a correction before too long.

5) Better Sources of Latin America Exposure
Investors who are keen on the long-term prospects of Brazil, Mexico, and their neighbors don't have to make a pure Latin America play. Diversified emerging-markets offerings usually devote 20% to 25% of their assets to the region, and they provide significantly more-diversified sector and stock exposure as well as much broader geographic exposure. The diversified emerging-markets category is quite sizable and includes several very attractive offerings.

Conclusion
For all these reasons, we believe that investors who are keen on the markets south of the border would be better off if they steered clear of the Latin America category and instead slowly dollar-cost averaged into a good diversified emerging offering with reasonable costs. Some of our favorites include   American Funds New World NEWFX,   Oppenheimer Developing Markets ODMAX,   SSgA Emerging Markets SSEMX, or   T. Rowe Price Emerging Markets Stock PRMSX.