Playing the Commodities Bull, Latin Style

This column was originally published on RealMoney on Oct. 11 at 1:24 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

Many very smart investors, including Jim Rogers, believe we are in the first few years of a 15- to 20-year bull market for commodities. That's one of a number of reasons to diversify your portfolio with exposure in Latin America.

Besides being commodity and resource rich, the Latin markets historically have a low correlation to the S&P 500. As emerging markets, they tend to have much bigger swings up as well as down.

Latin America turned in an excellent performance last quarter, but as I predicted last week in Columnist Conversation, a pullback in the region has gotten under way. The bigger markets in the region fell 5%-8% from the end of the quarter to Thursday's close. Now is certainly a better entry point, but there could be more room to fall.

Three exchange-traded funds from iShares invest in the region: iShares Latin American 40 Index Fund ( ILF), iShares MSCI Mexico Index Fund ( EWW) and iShares MSCI Brazil Index Fund ( EWZ). In addition to the ETFs, there are at least half a dozen closed-end funds, many open-end funds and, of course, individual stocks.

When looking under the hood of the three ETFs, it should not be a surprise that there's a lot of sector overlap and that the three have a high correlation. Materials investments comprise 28% of iShares Latin America, 29% of iShares Brazil and 17% of iShares Mexico. iShares Mexico has 40% in telecom (heavy telecom exposure is common in emerging markets), but it still trades similarly to the other ETFs. I believe this is because resources and energy drive the economic cycles of all of these countries and spur demand for the corresponding equities.

As is the case with most regional and single-country ETFs, the top few holdings have a sizeble weight. I don't think it invalidates the premise, but it's worth knowing that 24% of iShares Brazil is allocated to the common and preferred issues of Petrobras ( PBR), and 23.5% of iShares Mexico is invested in America Movil ( AMX).

iShares Latin American ETFs
The S&P Latin America 40 Index Fund (ILF), MSCI Mexico Index Fund, (EWW) and MSCI Brazil Index Fund (EWZ) have similar track records over the past two years.
Source: BigCharts.com

There is one major drawback to the ETFs compared with individual stocks, and that is dividends. Dividends are compensation for risk taken. Many Latin American ADRs yield 3%-5%. The ETFs, by definition, carry less risk, so the yields are much less.

The most important driver in deciding between a stock or investment product should be tolerance for volatility, not yield. With the ADRs, you take on more risk and get a higher yield; with the ETFs, less risk and lower yield.

Other risks are associated with investing in this part of the world that need to be considered before committing capital. The first is political.

In Brazil, bribery scandals seem to come and go, and Venezuela President Hugo Chavez has ideas about oil and governing that do not jibe with the Bush administration. Any negative catalysts that derail one country could easily spill over into any or all of the others in the region.

Tying into big swings in economic cycles is the potential, especially in Brazil, for high inflation and interest rates. Rampant local inflation would be an obstacle for equities.

Lastly, the increased global demand for commodities that seems so obvious may not be. If this theme unravels, you should expect any Latin exposure you have to do very badly.

The role Latin America plays in accounts I manage is to offer exposure to materials and emerging markets in a package with a low correlation to the U.S. Most clients have a roughly 4% exposure to the region with common stocks that pay a high dividend yield. I would expect an unraveling of the commodity theme to be very bullish for U.S. equities, and so any loss from this 4% weight would be more than offset by the lift here at home.

P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
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At the time of publication, Nusbaum was long PBR and AMX in client portfolios, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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