Brazil's Unloved ETFs Outshine Market Darling With 117% Windfall

(Bloomberg) -- To profit from Brazil's booming stock market, investors have poured billions into the nation's biggest ETF. And while the move has paid off handsomely, it's the fund's largely ignored, pint-sized rivals that have actually been the better bet.

The iShares MSCI Brazil Capped ETF now stands at $5.5 billion after adding $1.7 billion in the past year alone and returning 88 percent in that span. By contrast, smaller fund iShares MSCI Brazil Small-Cap ETF has lured just $13.2 million in the past year, while VanEck Vectors Brazil Small-Cap ETF has actually lost $20.4 million, Bloomberg data show. Still, they've returned 117 percent and 106 percent, respectively, over the same timeframe.

That outperformance is likely to grow even more stark as the smaller ETFs, which track mostly small-cap companies in sectors such as consumer discretionary and utilities, benefit from a rebound in Latin America's biggest economy, says Randall Shoker, president and CIO of Shoker Investment Counsel Inc. The iShares MSCI Brazil Capped ETF is more closely aligned with Brazil's Ibovespa Index, which is heavily weighted with commodity exporters whose fortunes are tied to swings in raw material prices and demand from China.

“In a world where China growth slows dramatically and commodity prices don't reflate dramatically but I still want Brazilian exposure, where am I going to be? That's going to be consumer cyclicals and consumer staples,” said Shoker, who owns the smaller ETFs. “And that market is still tremendously cheap.”

Despite being potentially more promising and boasting a better track-record of late, Brazil's tiny ETFs have drawbacks. The biggest is that they can prove tricky in the event of a market selloff when investors may struggle to reduce their holdings because of a lack of liquidity.

“These markets can move very quickly, and if you want to exit a large position, clearly it's much easier to do in EWZ than EWZS,” said Darshan Bhatt, deputy chief investment officer of Glovista Investments LLC, who holds the iShares MSCI Brazil Capped fund.

And while the small-cap funds have expense ratios that are similar to EWZ's 0.62 percent, they add costs in other ways. BRF's one-year tracking error of 6.36 percent -- the second-highest among unleveraged ETFs tracking Brazil -- may limit investors in more closely replicating the performance of the underlying index.

Still, the prospect of a more robust economic rebound in Brazil would be a boon for its small-cap companies, said Heidi Richardson, head of U.S. investment strategy at BlackRock's iShares. That bodes especially well for the country's smaller ETFs.

“The Brazil small-cap index is tilted towards the consumer discretionary sector, meaning it is a potential play on domestic investment themes and the domestic recovery,” she said. “If the economic recovery starts to really take hold, it could prompt more interest in Brazilian small caps, in particular if we start seeing signs of improvement in the labor market.”

To contact the reporter on this story: Carolina Wilson in New York City at cwilson166@bloomberg.net.

To contact the editors responsible for this story: Yakob Peterseil at ypeterseil@bloomberg.net, Rita Nazareth at rnazareth@bloomberg.net, Lester Pimentel