As worries continue to build over major emerging markets, many investors are looking beyond the Asian giants and closer to home. By doing this, some focus in on one of the giants of Latin America, Brazil, for potentially better investment opportunities.
However, the South American nation is also facing severe inflation problems, but its incredible commodity output, rapidly expanding middle class, and relative lack of competition in South America, have allowed the nation to skirt by some of the main issues that are hurting its major BRIC counterparts.
Still, the heavy dependence on commodities can be a double-edged sword, helping nations when markets are soaring but crushing them back to earth when commodity prices are floundering. This issue is particularly the case in Brazil with two of its enormous companies, Vale, and especially Petrobras (PBR).
Investors have developed something of a love-hate relationship with the South American oil juggernaut as the company has found some of the few massive oil fields as of late that are in a (relatively) friendly nation. However, the heavy government control and ownership of the company is seen as a determent by some, and the reason for a good deal of PBR’s underperformance and not living up to its potential (see Latin America ETFs Beyond Brazil).
This is best evidenced by the company’s most recent earnings report in which it posted its first quarterly loss in more than a decade. The company blamed a weaker real—which led to higher debt and import costs—as the chief reason for the miss, while it also highlighted a massive expansion in exploration costs, which moved higher by 400% in the period.
Even with this expansion, PBR has had little to show for the extra investment, at least so far. In fact, the company saw maintenance work and the closure of some wells push second quarter output lower by 2.4% in year-over-year terms.
Furthermore, since Petrobras doesn’t have the biggest refining capacity, the company has to import refined fuel at market prices. Yet, since the company is majority-government owned, it often resells this fuel on the home market at a loss, or keeps margins extremely low, helping ordinary Brazilians but hampering investor profits (see Are Investors Abandoning Brazil ETFs?).
In a recent Forbes article, Kenneth Rapoza summed up the situation nicely writing, “Petrobras is the class state run entity. It doesn’t exist to make shareholders profits. It exists for the commonwealth.”
Thanks to this weak earnings trend and the clear impact of government ownership on the firm, some may be considering avoiding PBR for the time being. Yet, it is also important to note that for ETF investors, avoiding Petrobras may take a little more effort.
That is because for those who wish to play a basket approach on the soaring Brazilian economy, the choice is usually the iShares MSCI Brazil Index Fund (EWZ). The fund has close to $7.5 billion in AUM and trades more than 15 million shares a day, thoroughly crushing the rest of the space on both metrics (read The Comprehensive Guide to Brazil ETFs).
However, the fund gives heavy allocations to both types of Petrobras shares, enough to give the company a 15.4% weighting in the fund. Clearly, this is a pretty significant allocation, suggesting that EWZ’s return is pretty much driven by just a handful of companies including the in focus PBR.
Thanks to this reality, many investors may want to consider cycling into different Brazilian ETFs in order to gain solid exposure to the region without the influence of the lumbering Petroleo Brasileiro. For these investors, we have highlighted three funds below which still offer solid exposure but without the dominating presence of the government-controlled Petrobras:
Market Vectors Brazil Small Cap ETF (BRF)
One of the best ways to avoid the giant Petrobras is by looking at small caps instead, such as with Van Eck’s BRF. This fund tracks the Market Vectors Brazil Small Cap Index, offering a cap weighted approach to the smaller companies in the nation.
By tracking this index, the fund has exposure to roughly 70 companies in total, putting no more than 5% in any one firm. Furthermore, materials make up just 7% of assets, putting assets instead in cyclical consumer companies and industrials which account for over half the portfolio (read Brazil Small Cap ETF Showdown: BRF vs. EWZS).
Unlike some of the other funds on the list, the volume on this one is pretty solid, suggesting relatively tight bid ask spreads. The product isn’t too expensive either, coming in at 59 basis points a year in fees suggesting it looks to be on par with EWZ from a total cost perspective.
Global X Brazil Mid Cap ETF (BRAZ)
If you are worried about the volatility of the small cap market, perhaps a mid cap focus with BRAZ is the way to go instead. The fund tracks the Solactive Brazil Mid Cap Index, giving exposure to a basket of medium sized companies, ensuring that Petrobras will be avoided.
In terms of BRAZ’s exposure profile, the fund is heavily exposed to utilities—further cutting down on volatility—while consumer staples and telecoms round out the rest of the top three. With this profile, a decent amount of large cap assets, and a low level in growth companies, investors could have a relatively low beta choice on their hands that gives quality and diversified exposure to Brazil.
Unfortunately, investors should note that the product is somewhat expensive at 69 basis points a year, 10 points more than BRF/EWZ. Additionally, volume is at roughly 13,000 shares a day so bid ask spreads could be relatively wide, potentially adding to total costs for large investors.
First Trust Brazil AlphaDEX Fund (FBZ)
For investors who want more of a large cap focus but are not willing to write off Petrobras entirely, you still have a quality option in FBZ. The fund takes a broad look at the market but evaluates stocks based on a number of growth and value factors instead of market capitalization levels (see more in the Zacks ETF Center).
With this approach, the top 50 stocks are selected, divided into quintiles and equally weighted in these five groups. However, the top quintile does receive an outsized weighting, descending to smaller weights for the worst ranked quintile.
This gives the fund a focus on utilities, basic materials, and consumer staples while mid and small caps account for roughly 45% of assets. Meanwhile, Petrobras makes up a very reasonable 2.8% of the fund, not enough to dominate the holdings profile, but worth mentioning nonetheless.
However, investors should note that the product does suffer from low volume levels and a weak amount of assets. This could contribute to higher trading costs, making the fund’s current expense ratio of 80 basis points more difficult to swallow.
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