Reform Momentum In Mexico Could Be Positive For This ETF

By Patricia Oey | Morningstar – Fri, Mar 22, 2013

Recent reforms in Mexico have not gone unnoticed by the global investment community. Since taking office in December last year, President Enrique Pena Nieto appears to be on track for a year of big-bang reforms. With the support of Congress, he has passed education reform and is in the process of opening up Mexico's highly concentrated telecom and television markets. On the agenda for later this year are measures aimed at increasing tax revenues and opening up the state-owned energy sector. These moves should help set the foundation for healthy growth in the medium term. Earlier this month, Standard & Poor's upgraded the outlook for Mexico's sovereign credit rating to positive from stable, signaling a possible upgrade in the next 18 months. That same day, the Mexican peso hit an 18-month high against the U.S. dollar. Some of this appreciation has been driven by strong foreign investment flows into Mexico. The Mexican central bank reported that in February, foreign investors poured a record $80 billion into the nation's stocks and bonds, almost 5 times more than flows into Brazilian securities over that same span.

One of the few ways to gain direct, diversified exposure to Mexican stocks is via iShares MSCI Mexico Capped (EWW). Like many cap-weighted emerging-markets equity indexes, EWW's index has some large single-stock exposures. For EWW, this outsized exposure is telecom giant America Movil (AMX), which currently accounts for about 17.5% of this fund's portfolio. The aforementioned moves toward reforming the domestic telecom market, as well as a less favorable regulatory environment in some of America Movil's other main markets, have weighed heavily on the stock over the past few months. So, while America Movil used to be a significant overhang on EWW, its current valuations suggest that a more challenging operating environment for the company is already priced in.

Now may be an attractive time for risk-tolerant investors to consider EWW, as it can be used to gain exposure to Latin America's growing middle class, who are likely to benefit from the planned reforms. Unlike most Latin American funds, this exchange-traded fund has a large exposure to consumer firms--which represent about 40% of the fund's portfolio. Many of these companies are large and highly profitable and have operations in the relatively faster-growing Central and South American markets.
Suitability
Historically, this fund has not provided significant diversification for U.S. investors. While most publicly listed Mexican companies have limited exposure to the U.S. market, the Mexican economy is fairly dependent on the health of the U.S. economy. Since the North American Free Trade Agreement was implemented in 1994, Mexico's role as a low-cost manufacturer for products destined for the U.S. market has steadily increased. Currently, exports to the United States account for about a fourth of Mexico's gross domestic product. This economic link may partially explain why this fund has a relatively high (88%) correlation to the S&P 500 over the past five years (to Feb. 28, 2013) compared with other emerging markets.

As for risk, this ETF's 10-year annualized trailing standard deviation of returns was 24.3%, in line with that of the MSCI Emerging Markets Index. Furthermore, this fund is fairly top-heavy, as its top 10 holdings account for a combined 62% of total assets.

Fundamental View

Since the devaluation of the peso and the economic crisis of the mid-'90s, Mexico's economy has been on a steady growth path, driven by sound macroeconomic policy and growing exports. Over the past few years, Mexico's economy and public finances have been on stable ground, with the country seeing steady job growth and mild inflation. More recently, Mexico's relatively attractive sovereign debt yields have attracted strong investment inflows into Mexican equities and debt, which in turn is supportive of the Mexican peso. All of these factors, plus this fund's defensive sector tilts, helped to drive EWW's 31% return in 2012.

Looking ahead, Pena Nieto has laid out a reform program that seeks to address many of the country's long-standing issues, such as inefficiencies in the labor market, underinvestment in the state-owned energy sector, and the government's dependence on oil revenue. If some of these plans come to fruition, it will be positive for Mexico's economy. Other near- and medium-term drivers for growth include a recovering U.S. economy, the return of some manufacturing previously lost to China as Chinese competitiveness begins to suffer thanks to wage inflation, and Mexico's young population.

EWW holds a number of highly profitable firms with entrenched competitive advantages. America Movil is one of the world's most profitable telecom companies, in part because of its dominant 70% share in Mexico's wireless market. Over the years, America Movil has used its ample free cash flows from its Mexican operations to fund international expansion, and it is now the largest wireless provider in the region, with about 200 million customers. A number of EWW's other large constituents have enjoyed a similar path to success, starting with a highly profitable stranglehold on the Mexican market, which ultimately funded international expansion. These companies include retailer Fomento Economico Mexicano (FMX) , bottler Coca-Cola Femsa (KOF), and building materials company Cemex (CX) (though this company continues to be financially strained as a result of an ill-timed expensive acquisition in 2007).
Investors should keep the following risks in mind when considering this fund. First, while the president's reform initiatives are designed to stimulate competition to benefit the economy and the local consumer, they may have a negative impact on some of the large holdings of this fund--specifically telecom and television companies--many of which have long benefited from a favorable regulatory environment. Second, drug-related violence continues to be an issue, and the government estimates that this violence is costing the country 1 percentage point of GDP growth per year. Lastly, Mexico's national budget is highly dependent on tax revenues from the state-owned oil monopoly Pemex. Falling production levels at Pemex and/or lower oil prices would negatively impact Mexico's budget.

Portfolio Construction

On Feb. 11, 2013, this ETF changed its benchmark index from MSCI Mexico IMI Index to MSCI Mexico IMI 25/50 Index. MSCI's 25/50 indexes are designed to take into account U.S. IRS investment constraints needed for a fund to qualify as a Regulated Investment Company. According to the 25/50 Index rule, no single issuer can exceed 25% of the index, and the sum of all issuers whose weighting is above 5% cannot exceed 50% of the index. As of Feb. 28, 2013, constituents with a weighting in excess of 5% accounted for a total of 65% of the standard MSCI Mexico index's value.

If the fund had not changed its index, it could have incurred substantial tracking error. This fund does not hedge its foreign-currency exposure. At this time, this ETF employs full replication to track its benchmark, which is composed of 44 stocks. The index is capitalization-weighted and aims to capture 99% of the total market capitalization of the Mexican market available to foreign investors.

Fees

EWW's expense ratio of 0.50% is in line with regional Latin America ETFs.

Alternatives

For investors interested in broader exposure to Latin American stocks, there is iShares S&P Latin America 40 Index (ILF). Another option is SPDR S&P Emerging Latin America (GML), which has similar country weightings to ILF's but is significantly less liquid. The expense ratios for ILF and GML are 0.50% and 0.59%, respectively.

There are no other ETFs or open-end mutual funds that invest exclusively in Mexican stocks. Those who understand the ins and outs of closed-end funds can consider Mexico Fund (MXF) and Mexico Equity & Income (MXE).

Patricia Oey will be a panelist for the "Smarter International Investing" session of the Morningstar Individual Investor Conference, which will take place on morningstar.com on Saturday, March 23.

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