1 Sign This Latin American Market Is Getting Dangerous

Investors have looked to emerging markets for more than a decade as an alternative to the low growth rates that have held back much of the developed world. But not all emerging markets are the same, and different markets have to follow their own paths in charting a course for greater prosperity. Changing conditions among markets require that you pay attention to make sure the return potential is in line with risk levels.

One area where emerging-market investors have focused lately is Latin America. For a long time, Brazil has been the giant of the Latin American economy, with a rising middle class, vast wealth in natural resources, and an appetite for growth. But lately, investors have shifted their focus northward to Mexico, and interest in the Mexican stock market has risen to frothy levels.

Why Mexico has gotten more popular
U.S. investors know quite well how much impact a presidential election can have on the markets, and things are no different with our neighbor to the south. Last July, Mexican President Enrique Pena Nieto got elected, taking office in December and replacing former President Felipe Calderon. As Fool contributor Michael B. Lewis noted shortly before Pena Nieto took office, the change in government offered a much different relationship between the U.S. and Mexico, with less of an emphasis on the negative aspects of drug trafficking and violence and more on free trade and attracting direct foreign investment.

The impact has been huge. Consumer stocks have performed strongly as conditions have improved, resulting in a big move up for beverage maker Fomento Economico Mexicano (NYSE: FMX  ) . Meanwhile, improving prospects for construction have helped pull up shares of cement manufacturer Cemex (NYSE: CX  ) .

As a result, money has flooded into the Mexican stock market, and as The Wall Street Journal reported yesterday, exchange-traded funds covering Mexico have attracted huge amounts of cash. The iShares MSCI Mexico ETF (NYSEMKT: EWW  ) has brought in $1.4 billion during the past year, while the corresponding iShares MSCI Brazil ETF (NYSEMKT: EWZ  ) has had outflows of roughly $236 million over the same period.

Why paying a premium for Mexico isn't smart
There's evidence that investors are paying too much to get into the Mexican market. The closed-end Mexico Fund (NYSE: MXF  ) has historically had its shares trade at a substantial discount to their net asset value, with discounts approaching 30% during the 2000-2002 bear market and 20% during the financial crisis. In simple terms, selling shareholders in the funds were willing to accept $0.70 to $0.80 on the dollar in order to cash out.

But now, those same closed-end fund shares trade at a 10% premium to net asset value. Mexico Fund's holdings aren't identical to those of the iShares Mexico ETF, whose shares trade in line with the value of its assets, but the two lists of holdings have a lot of similarities.

Investors are also attracted to Mexico Fund's managed distribution policy, which ensures a much higher payout yield than the iShares ETF. But much of that payout ends up coming from long-term capital gains rather than current dividends, potentially misleading investors about the source of their income.

Tread carefully
Mexico Fund isn't the first closed-end fund to trade at a massive premium, and it could get larger if investor interest remains high. Eventually, though, most premiums disappear, hurting investors who buy with the promise of securing big returns. With the fund having risen 55% just since mid-November, it looks like new investors have already missed out on the biggest returns for Mexico Fund and its exposure to the Mexican stock market.

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Related Tickers

4/23/2014 4:02 PM
CX $12.49 Up +0.09 +0.73%
Cemex CAPS Rating: ****
EWW $63.35 Down -0.41 -0.64%
iShares MSCI Mexic… CAPS Rating: **
EWZ $47.08 Down -0.07 -0.15%
iShares MSCI Brazi… CAPS Rating: ****
FMX $91.49 Down -1.54 -1.66%
Fomento Economico… CAPS Rating: ***
MXF $26.30 Down -0.11 -0.42%
Mexico Fund, Inc. CAPS Rating: ***

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