Mutual funds focused on Latin America have been among the market's top performers lately, and strong fundamentals, high commodity prices and favorable interest rates could help them surge further.
Faced with what many see as sleepy domestic returns, U.S. investors have increasingly turned to emerging markets, which have posted blistering hot numbers in recent years. According to the Morgan Stanley Capital International indexes, which professional investors use to track regional performance around the globe, emerging markets as a whole gained 111 percent over the past 36 months, and Latin American stocks rose 179 percent during that period. By comparison, the U.S. equity market advanced 44 percent.
So far this year, Latin American markets are outpacing the United States as well. The U.S. MSCI index is up 3.2 percent, while Chile added 18.6 percent, Mexico rose 19.6 percent, Brazil gained 20.3 percent and Argentina skyrocketed 47.8 percent.
"This very, very strong outperformance reflects a nice combination of fundamentals, and also the fact that investors have been really scouring the globe looking for high returns, which don't seem to be so evident in Europe and North America," said Michael T. Porter, senior research analyst with fund-tracker Lipper Inc.
Such numbers are hard to ignore, but Porter and other experts say there's good reason to think twice before chasing this performance, or investing in niche funds to begin with. Narrowly focused regional and country funds are risky to begin with, and on a valuation basis, Latin American funds are not as attractive as they were a year ago.
"I would look for some type of pullback before committing funds to the region," Porter said. If and when you do invest, he added, "start with a regional fund which allows the portfolio manager to determine timing issues and market exposure and asset allocation, and only as your comfort level increased would you consider a single country fund, because they become more risky."
Tight fiscal and monetary policies -- which resulted in higher interest rates in several markets -- have contributed to greater stability in Latin America. The economy grew roughly 6 percent as a whole last year, after five years of stagnation, and is expected to grow an additional 4 percent this year. That's a sharp turnaround from 2002, when a debt crisis in Argentina hurt the region.
Key to the success of Latin America (and emerging markets in general) is the fact that interest rates in the United States and Japan are still at historic lows. This makes high-yielding assets attractive, which is beneficial because it tempts the global investor to buy emerging market debt, and helps generate foreign direct investment. On top of that, currency appreciation has reduced the relative burden of dollar-denominated debt.
The combination of low rates and high commodity prices creates a favorable outlook for Latin American economies, which are very dependent on exports of minerals and farm products. At least some of the boom can be linked to surging demand from China for things like oil, copper and iron ore.
Among the risks attached to investing in emerging markets in general, and Latin America in particular, is the possibility of a precipitous rise in U.S. interest rates. If rates shot up, the appetite for riskier high-yield debt would likely wane in favor of safer investments at home, such as government paper. In addition, any change in China's growth could undermine the booming market for commodities, which make up some 30 percent of the region's export revenues. Politics could also threaten long-term prosperity. There's a broad field of candidates for Mexico's 2006 presidential race, and Brazil's government has been plagued by a corruption scandal.
Overall, a lower savings rate, relatively high indebtedness and institutional weaknesses, including extreme social inequality, hobble the region's ability to make sustainable economic progress. This makes it more vulnerable to fluctuations in rates and commodity prices.
For these reasons, the average investor should think carefully before devoting significant assets to Latin America.
In fact, some financial planners doubt the wisdom and efficiency of investing in single region or country funds at all. Among other considerations, regional funds often have high expenses because of greater transaction costs. And when it comes to Latin America, there aren't many choices -- just a handful of actively managed portfolios and a few exchange traded funds.
If you are a very sophisticated investor with a large portfolio, and all your other bases are covered and you are comfortable with the risks, modest exposure to a Latin American fund may make sense. But for most people, a broadly diversified international fund that divides its exposure to many parts of the world, including Latin America, would be a better bet, said Gary Schatsky, a fee-only financial planner in New York.
"People have been chasing international funds, much like they've been chasing commodities and real estate, but don't just jump on the bandwagon because they've been hot," Schatsky said. "It's natural to be wowed by these returns, but that 'wow' could quickly turn into a 'whoa' if things turn sour, and investors may be sorry if they're overweighted."