Time For the Latin America Small Cap ETF? (LATM, ILF, GML)

Eric Dutram: Most investors and other market participants usually think about China and India, whenever there is any talk about the emerging markets. While these two emerging giants have been investors’ delight for a long time now, it is prudent and timely to think of other emerging markets which have managed to draw investors’ attention (see Forget the BRIC ETFs, Focus on the PICKs).

Investing in Latin American economies can be a lucrative option for investors seeking exposure in the emerging market space. Not only does the region have favorable demographics, but it is also rich in natural resources.

These positives have persuaded investors from all over the world to shift focus to these markets. It has resulted in an increase in foreign capital flows in the form of direct investments and portfolio investments to Latin America throughout the past decade. The above- par economic growth of the region, mainly thanks to its rising middle class population leading to increased consumption and investor-friendly economic policies are key positives from an investor’s point of view going forward.

Over the past decade the Latin American region has seen solid levels of growth and development, especially due to the commodity boom as most of these nations are commodity exporters. Also, the above-par growth in the world’s second largest economy and the largest trading partner of the Latin American region — China, have gone a long way in achieving the strong economic growth (seeChina Small Cap ETFs Holding Their Ground).

Having said this, it is prudent to note that the region is heavily dependent on the global economic environment, especially given its strong focus on exports to other nations. Commodity prices worldwide have been under pressure for quite some time now, given the generic slowdown in global economic conditions (readTop Commodity ETFs In This Uncertain Market).

Also, the Chinese economy has been struggling to keep up the strong growth in its industrial production and the broader economy. This has led to reduced commodity consumption for industrial purposes resulting in declining commodity imports from the Asia-Pacific region and the Latin American economies.

Nevertheless, the outlook for the region remains positive as its growth is likely to be fuelled by its rising middle class population and the massive potential that the region possesses.

For investors looking for a pure growth play in the interesting slice of the market, a small cap route is a risky proposition, although the potential that it possesses outpaces the risks handsomely. The Market Vectors Latin America Small Cap ETF (NYSEARCA:LATM) can be a great pick (and pretty much the only option) for investors seeking a basket exposure in the small cap space of the region (seeEmerging Market Small Cap ETFs: Freefall Continues).

Launched in April of 2010, LATM really has nothing substantial to boast about in terms of its past performance. The ETF has been one of the worst performers in the broad- based Latin American equity space in the past year slumping 23.49% in the last one year period as of  July 31, 2012.

Of course, other broad based Latin American ETFs belonging to the large cap family have also slumped pretty badly in the last one year period; however LATM seems to be leading them in the downside.

It is a known fact that small caps are generally more volatile than mid/large caps and they tend to outperform their large cap peers in times of an uptrend, however the flip side also holds true.

Table: 1

ETF Focus Exp. Ratio Total Assets Yield No. of Holdings % In Top 10 1 Year Returns YTD Returns 1st Qtr Return 2nd Qtr Return
GML Large Cap 0.59% 109.87 million 2.91% 116 39.60% -14.04% 1.88% 14.31% -12.35%
ILF Large Cap 0.50% 1.60 billion 3.13% 41 62.82% -12.40% 0.42% 12.08% -11.98%
LATM Small Cap 0.63% 12.93 Million 2.07% 149 20.49% -23.49% -0.14% 16.23% -15.37%

(Note:i) 1 year and YTD Returns are as of July 31, 2012)

As is evident from the table above (Table 1), the small and large cap ETFs more or less follow the same trend. The large caps i.e. iShares S&P Latin America 40 ETF (NYSEARCA:ILF) and the SPDR S&P Emerging Latin America ETF (NYSEARCA:GML) both belong to the large cap category and follow a similar trend to LATM.

For example, on a one year basis all of the three funds have performed poorly, however, the slump in LATM (-23.49%) is more than the fall in GML (-14.04%) and ILF (-12.40%). Since the beginning of this year all three ETFs seemed to pick up pace, mainly due to the broader market recovery in the U.S and some sort of optimism from the Eurozone.

For the first quarter of 2012, all the ETFs ended in the green with LATM leading the way in the upside as well. The situation quickly reversed in the second quarter as then again LATM underperformed its large cap peers and slumped 15.37% during the quarter. On a year-to-datebasis, all three ETFs were flat (readBeyond Corn: Three Commodity ETFs Surging this Summer).

Of course, the ETFs track the same geographical region and there is bound to be a similar trend between the ETFs, irrespective of their capitalization levels. However, as is evident from the table and the discussion, the magnitude tends to vary between capitalization levels.

LATM is heavily exposed to the commodity companies with around 28% allocation towards the material sector and around 5% to the energy sector. Therefore falling commodity prices (leading to decreased revenues and margins for the commodity based companies) coupled with a small cap focus resulted in a steep decline in its share price.

However, its large cap peers GML and ILF also have heavy allocations towards the commodity based companies. GML has 20% allocation towards the material sector and 11% towards the energy sector, whereas ILF has around 17% allocation towards the material sector and 12% towards the energy sector (see Natural Gas ETFs: Futures vs. Equities).

Nevertheless, both GML and ILF place their bets on larger and better known brands, which have the upper hand both in terms of investor confidence and stability. Moreover, the volatility tends tp be lower for their larger cap constituents.

Large cap ETFs are exposed to export oriented commodity based companies which draw most of their revenues from offshore markets, making them highly vulnerable to the global trends. The smaller companies on the other hand are somewhat limited in their exposure to the foreign markets as they mostly cater to their respective domestic markets (see more in the Zacks ETF Center).

Adding to the uniqueness of LATM is its low levels of correlation with the broader U.S equity markets. LATM has an R-Squared value of 46.28% with the S&P 500 based on its daily returns since its inception. On the other hand its large cap peers GML and ILF have R-Squared values of 73% and 77% respectively on a similar basis and for the same time period. Therefore LATM is also an appropriate choice for an international diversification play for U.S investors.

Therefore, we see that amongst all the negativity surrounding the Latin American small cap ETF LATM, there are a few positives which could go a long way in creating value for investors. This is especially so, given the fact that the ETF has already seen massive corrections in its price of late and its share price finally seems to be bottoming out.

Written By Eric Dutram From Zacks Investment Research  

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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