Can Latin American Stock Funds Continue Their Run?

Latin American funds rallied this year. As of this writing, they were by far the best-performing category among International Equity funds, up nearly 25% for the year. But the region will likely face hurdles in 2017 that may be hard to overcome.

"The main reason that Latin American markets have performed well this year is because of the boost from Brazil. Brazil dominates that category," said Gregg Wolper, senior fund analyst at Morningstar. Brazilian stocks make up more than 50% of the MSCI EM Latin American Index.

Brazil rebounded this year from a dismal collapse in 2015. One of the largest commodity exporters in the region, Brazil experienced a crippling recession in 2015 due to plummeting commodity prices, a corruption scandal in state oil firm

Things turned around for Brazil--and therefore, for Latin American equity funds--in 2016.

Earlier this year, there was some resolution in the political crisis when the embattled president was replaced, calming global investors. A rebound in commodity prices also helped investor sentiment. And the Brazilian real appreciated more than 16% against the U.S. dollar in 2016, giving some respite to U.S.-based investors buying or owning a Latin American fund.

But as the saying goes, past performance is not indicative of future returns. A few variables are at play that may provide headwinds for Latin American funds in the new year.

For starters, the election of Donald Trump as president of the U.S. is already causing volatility and uncertainty in the region, due to his comments during the campaign about trade and immigration.

Mexico has been the hardest hit so far. The Mexican stock market has dropped about 6% since President-elect Trump's victory, and the peso, which acted as a barometer for sentiment, plummeted 13% after the election due to Trump's promises of protectionism and a tough immigration stance, including the building of a wall along the border.

Should Trump follow through in 2017 with his pledge of renegotiating the North American Free Trade Agreement with Mexico and Canada or impose trade barriers, Latin American economies could be hard hit.

Brazil faces some economic risks in the wake of the U.S. election, too. U.S. agricultural companies are lobbying the president-elect to set up trade tariffs on raw materials or agricultural products such as sugar, soybeans, and grains. Such tariffs would represent a large hurdle for these countries' economies and therefore pinch exports.

But sometimes what may seem a clear reality may not be the actual result, Wolper says.

"If the U.S. economy strengthens, if there is a lot of infrastructure spending, then Mexico, being the third largest trading partner with the U.S., wouldn't hurt as much, regardless of what happens with U.S. trade tariffs and NAFTA," he said.

Other challenges facing the emerging markets of Latin America in general are rising in U.S. interest rates and a stronger U.S. dollar.

Investors tend to bet in emerging economies because of the implied premium these companies offer for what's perceived as a riskier asset. But when U.S. interest rates rise, investors may have less incentive to buy assets in riskier markets when they can get a good enough return in "safer" U.S. markets.

As rates rise and investors repatriate money to the U.S., the dollar appreciates. For example, by the time it happened, investors had already priced in the interest-rate increase set by the Federal Reserve on Dec. 14. By late November, the U.S. dollar had touched a 13-year high, according to the ICE Dollar Index, which gauges the U.S. currency against a basket of six other currencies.

Lastly, the Brazilian corruption scandal and the government's stability and strength of their policies are yet to be resolved, though emerging markets and Latin American economies are expected to grow 1.1% in 2017, from a forecast 2.0% contraction in 2016, according to the IMF.

"The recession may be nearing its end, but the implementation of reforms that address structural problems, including in the fiscal arena, and that durably restore policy credibility and growth remains uncertain," notes the IMF Regional Economic Outlook report.

That said, investors with iron wills may still be interested in investing in the region. Morningstar doesn't award Medalist Ratings in this category, because these funds tend to be such narrow investments.

"It is a universe dominated by a few markets, a handful of sectors, and a limited number of names," said Morningstar senior fund analyst William Rocco. There are only 121 stocks in the index, with the 10 largest names making up 35% of assets, he added.

That said, a few of the major fund families--including Fidelity and T. Rowe Price--offer active funds dedicated to investing in Latin American equities.

T. Rowe Price Latin America PRLAX focuses on industry leaders in Brazil, Mexico, Peru, Chile, Argentina, and Colombia. More than 60% of the fund is invested in Brazilian stocks. The fund, with more than $578 million in assets, has

The $537 million Fidelity Latin America FLATX has returned nearly 20% so far this year. Managed by Will Pruett since October of last year, the fund has an expense ratio of 1.12% and counts

Passive options among ETFs include SPDR S&P Emerging Latin America ETF GML, which tracks the S&P Latin America BMI Index and has returned more than 28% this year. The $26 million ETF carries a 0.49% expense ratio. It invests 58% of its assets in Brazil, 26% in Mexico, 9% in Chile and almost the rest in Colombia and Peru. Its top holdings are Brazilian firms such as Itau Unibanco, Banco Bradesco, Ambev, and Petrobras.

iShares Latin America 40 ETF ILF tracks the S&P Latin America 40 Index. With an expense ratio of 0.49%, this $1 billion ETF has similar exposure as the previous funds to top Brazilian financial, consumer staples and energy companies. It's up 33% this year.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.