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Fund Spy

An Inside Look at 2009's Best-Performing Fund Category

One country plays a very big role.

If Christmas sales can start in mid-November, why wait until year-end to discuss 2009's investing success stories?

With that idea in mind, a Fund Spy column from a few weeks ago looked at one of the best-performing funds of 2009 to see how it had achieved its gains and examine what the fund is all about. This time, we'll look at the best-performing category of the year.

With one month to go, it seems unlikely that any other group will overtake the Latin America category as 2009's best performer. Through Thanksgiving Day, those funds have soared an average of 117%--more than double the gain posted by any U.S. stock category, including hot specialty groups such as technology and energy. In second place is the diversified emerging-markets category, which itself owes its gains partly to Latin America: The typical fund in that category has 22% of assets in that region.

The Story behind the Story
The surprise: Aside from leveraged portfolios and exchange-traded funds, there are only five open-end Latin America mutual funds. That number once was a bit higher, but interest in the funds waned, and some merged into broader emerging-markets siblings. Some of the remaining funds have multiple share classes, so a screen for this category will show more than 20 different names, but don't be fooled. It's a tiny group. (A month-old offering from Dreyfus also lands in the Latin America category, but it focuses only on Brazil.)

Two more funds that we include in the category are leveraged, which means they gain much more than the market in good times and lose far more when markets plunge. This year, they've soared: These leveraged funds, ProFunds UltraLatin America (UBPIX) and Direxion Monthly Latin America Bull 2X (DXZLX), have each gained more than 190%. In such a small group, the outsized returns of those two funds alone gave the category average a significant boost, but Latin America would still stand as the best-performing category even without them.

A ProFunds inverse-leveraged Latin America fund takes the opposite bet, and it has lost nearly 86% this year. But we include that fund in the bear-market category with all other bear-market or inverse funds, figuring that most people searching the Latin America category want to buy into, not bet against, the region.

The main reason for the category's huge gain is this year's trend, visible across the investing spectrum, away from the most defensive, cautious assets in favor of more daring plays. Nearly all emerging markets have enjoyed excellent gains since March. Among those, Brazil has been a major star; the MSCI Brazil Index is up more than 120% so far this year. Investors like Brazil because it is considered one of the most stable emerging markets politically, has one of the biggest economies of all emerging markets, suffered less than many others in the financial crisis, has an impressive growth rate, and has the broadest stock market in the region.

Two Brazilian stocks in particular gain the attention of international investors when the global economy seems to be healthy or heading that way. (Especially when China's voracious appetite for commodities seems intact.) They are oil giant  Petroleo Brasileiro (PBR), commonly known as Petrobras, and  Vale (VALE), one of the world's biggest iron-ore producers.

Big Brazil
To a large degree, the strength of Brazil's market determines this category's fortunes, for Latin America funds are essentially Brazil funds, with some Mexico mixed in. They do not provide broad, balanced exposure across a wide variety of Latin American stock markets. Brazilian stocks typically make up 65% to 75% of these portfolios, with Mexico at 15% to 20% or so.

The concentration doesn't end there. In the most recent portfolios, Petrobras alone takes up about 15% of assets--sometimes more. You might not notice that at first, for some show Petrobras as the top holding with, say, 8% of assets. The explanation is that funds often own part of their Petrobras stake in local shares on the Sao Paulo exchange and another portion in ADRs traded in New York. Adding the two separate lines in the portfolio together reveals the fund's total exposure to the stock.

The next few stocks in these portfolios also get unusually high allocations. Stakes of 7% in Vale and Banco Itau are not unusual. That's some serious concentration in just one country and a few stocks.

Sometimes extreme concentration pays off: The Petrobras ADR is up 118% this year.

Exchange-Traded Funds
The small number of Latin mutual funds doesn't mean interest is lacking.  T. Rowe Price Latin America (PRLAX) has $2.6 billion in assets, and  Fidelity Latin America (FLATX) has $4.2 billion between its retail and advisor shares. Moreover, many investors tap into Latin America through ETFs instead of mutual funds.

Two ETFs in particular have gathered a substantial amount of assets.  IShares S&P Latin America 40 Index (ILF) has about $3 billion in assets. Even more investors have decided to take the Brazil focus one step further:  iShares MSCI Brazil Index (EWZ), which owns stocks in only that country, has more than $11 billion in assets. This one ETF has more money than the entire Latin American category of conventional mutual funds, including all the various share classes and leveraged portfolios.

The ETFs are cheaper than the mutual funds and offer investors the only index-tracking alternatives (there is no Vanguard Latin America Fund). However, they share the same concentration issues as the mutual funds. Note that iShares S&P Latin America 40 Index has 40% of its portfolio devoted to just the three heavyweights: Petrobras, Banco Itau, and Vale. And Petrobras alone currently makes up 22% of iShares MSCI Brazil Index's portfolio.

Final Thoughts
One can't expect gains of 100% and more to come around very often in any sector or region, no matter how quickly it's growing. And those that do post such gains tend to fall hard when conditions turn even a little sour. So tread carefully, especially given the uneven country exposure and extreme concentration featured in these funds. Ideas Week
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Gregg Wolper does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.