Investing in Latin American countries certainly has its risks, but with the economies of these nations growing at nearly a double-digit pace, they might deserve a place in your portfolio.

As with all emerging-markets funds, there are caveats.

The recent negative returns of the funds I discuss in this column are of some concern to investors, but the subpar performance may be due to the inherent volatility of the region, and emerging markets in general. Rumors or a shift in sentiment can cause large fluctuations in these types of markets, as shown in May/June 2006 when interest rate rises (

Fed

-tightening) led to declining returns in most emerging markets.

A few weeks later, investors were back on board with emerging markets and since then, these markets, and the funds invested in them, have more than recovered the lost ground. The market overreacted to the rate increase and punished these markets for no reason; the fundamentals of these economies never changed. The only thing that seemed to change was the sentiment toward them. The same thing seems to be happening now.

In chaos there is opportunity -- if you are capable of taking the risk and you think interest rates in the U.S. will go lower in 2007, then emerging-market plays are a good way to place your bets.

For investors looking to add a little Latin American spice to their investments, there are a couple of strategies you can employ.

You could use a regional fund that takes position in a few Latin American countries; or you could take position in a country-specific fund that focuses on one particular country. We're going to take a look at both strategies, looking first at our top-rated regional funds and then comparing the top-rated country-specific funds.

The Regional View

Our models have identified two regional funds that are worth a look: The

iShares S&P Latin American 40

(ILF) - Get Report

(we rate it an A minus), and the

Latin American Discovery Fund

(LDF)

(which we rate a B).

The iShares S&P Latin American 40 is an exchange-traded fund that seeks investment results in line with the S& P Latin American 40 Index.

The Latin American Discovery Fund is a closed-end fund with an objective of long-term capital appreciation, and it currently trades at a reasonable discount to its NAV of 7.44%. A rough guide for closed-end funds is that a discount of 10% is considered attractive.

Taking a look at the regional breakdown of these funds, we see that the best-performing Latin American regional funds have a focus on Brazil and Mexico, with Brazil carrying the heaviest weighting.

It's also important to check out these funds' sector allocations. You can see from the tables below that LDF favors oil and gas over telecommunications, while ILF has done the opposite.

Recent declines in the price of crude oil and energy in general may suggest that ILF has the better sector allocation for the near future. The price of crude oil per barrel has fallen around 25% from summer highs in the $70 range to recent closes in the high $50s.

That said, it is difficult to predict the direction of prices. OPEC is looking to stabilize the price by cutting production, but getting OPEC's members to act in concert is proving harder than first thought, with Saudi Arabia apparently reluctant to cooperate with the cuts. Natural gas prices also have fallen in line with a buildup of inventories in the U.S.

So the high prices that delivered bumper profits to the energy companies may be a thing of the past. Going forward, lower prices equate to lower earnings for these companies -- and lower returns for funds that are exposed to them.

The holdings show both funds have a concentrated strategy with approximately 60% of fund assets in the top 10 holdings. Concentrated strategies do have higher levels of risk, but this strategy also can generate higher returns.

Taking a look at the funds' returns, the key issue here for returns going forward is that LDF's heavy weight in oil and gas is hurting its near-term results, as shown by the one-week figures (as of Oct. 22). LDF is down 1.17% while ILF has fallen only 0.13%. (GDUEEGFL is the Citigroup Latin American DR Total Return Index.)

If we leave interest rate concerns aside, LDF has a better long-term track record, but going forward, ILF could generate higher returns because of its reduced focus on the oil and gas sector.

The Country-Specific View

For those investors looking to Latin American economies, our models suggest that a focus on Brazil or Mexico (or both) is key to capturing the best returns from this region.

Let's look at the alternative investment approach using country-specific funds. For Brazil, we will use the

iShares MSCI Brazil

(EWZ) - Get Report

, which we rate a B, the highest-rated fund we have for this country. For Mexico, we will look at the

Mexico Fund

(MXF) - Get Report

, which we rate an A.

Please note that there are two other Mexican funds that made our top 200 list -- the

iShares MSCI Mexico

(EWW) - Get Report

(rating: A minus) and the

Mexico Equity & Income Fund

(MXE) - Get Report

(rating: B). MXE has been

written about previously. Investors also may want to consider these in terms of Mexican exposure.

The table below shows some regional economic statistics. Mexico and Brazil are economies of similar size, but Mexico has the better economic numbers across the board, barring the current account comparison (as a rough guide, a current account deficit approaching 6% of GDP is considered a danger zone, especially for emerging economies. With Mexico at 0.6%, this is not bad at all.

Now let's take a look at the two highest-ranked funds for Brazil and Mexico.

The Mexico Fund Inc. is a nondiversified, closed-end investment company that seeks long-term capital appreciation from equity securities listed on the Mexican Stock Exchange. As of Oct. 25, the fund traded at an attractive discount of 12.05% to its net asset value. The iShares MSCI Brazil fund is an exchange-traded fund that is designed to produce results in line with the MSCI Brazil (Free) Index (NDUEBRAF). MXF has only 30 stocks in its entire portfolio (hence the nondiversified tag) while EWZ has a total of 54 stocks in its portfolio.Below are the relative returns for each fund, as Oct. 23:

The Mexico Fund has better long term results, and with the exception of the one-month figure, is also performing better in the near term as gauged by its year-to-date, three-month and one-week figures.

The key item to look for in the sector holdings below is the heavy weight that EWZ has in the oil and gas sector -- this could be the reason for the much lower one-week return the fund has. This sector has been adversely affected by the recent declines in energy prices, especially crude.

The top 10 holdings show both funds having concentrated portfolios, with the top 10 assets accounting for 55.19% and 66.12% for MXF and EWZ, respectively.

In conclusion, what we learn from the above is that:

  • Any Latin American investment should be focused on Mexico and Brazil.
  • Avoid the oil and gas sector.
  • All funds employ concentrated strategies with a high percentage of assets in the top 10 holdings.
  • The regional funds have similar holdings to the respective country-specific funds.
  • Despite both regional funds having a heavier weighting toward Brazil, the economic figures show Mexico to be the healthier economy.
  • MXF presents the best individual investment opportunity because of its focus on Mexico and its sector allocation, which avoids the oil and gas sector.
  • Inflation and interest rate fears in the U.S. will change sentiment toward these types of economies -- investors should stay focused on fundamentals.

An alternative strategy is for investors to create their own regional fund and adjust the allocation more in favor of Mexico by taking say a 60%-40% split between MXF and EWZ. There are various combinations between the four funds that can be implemented, and investors should consider their own individual risk tolerances in constructing any investment portfolio.

Sam Patel, CFA, is the manager of mutual fund Research for the TheStreet.com Ratings.

In keeping with TSC's Investment Policy, employees of TheStreet.com Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Patel cannot provide investment advice or recommendations, he appreciates your feedback;

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