No Siesta for This ETF

The Mexican economy is gaining momentum, having grown 4.5% in 2006. Internationally minded investors looking to spice up their holdings with a shot of that economic hot sauce might consider the iShares MSCI Mexico Index (AMEX:EWW). Invest with caution, though -- despite its fine performance, the fund has a few glaring weaknesses.

EWW spiked like a hot pepper in 2006, rising 44% on the strength of the overall rally in Mexican stocks. The fund tracks the MSCI Mexico Index and charges a moderate expense ratio of 0.54%.

EWW's top five holdings account for slightly more than half the fund's assets:

The fund has its heaviest sector exposure in Wireless Telecom, at 27%, with 15% in construction materials and 12% in diversified telecomm.

Tequila hangover
Mexico's highly volatile stock market means that EWW's price can fluctuate widely. Mexico is acutely affected by any changes in the U.S economy, and for the past few years, it's benefited from a strong market to the north.

Still, Mexico's economic growth has not yet lived up to its full potential. In part, this failure results from the country's difficulties in enforcing property rights, but it's also due to Mexico's endemic corruption and large underground economy.

Lenders in Mexico are less willing to make loans, uncertain of repayment or the ability to collect on collateral in case of default. That doubt creates poor investment allocation, and hinders businesses' production to smaller-than-optimal scales. The large untaxed and unregulated portion of economic activity, which may account for as much as one-third of the nation's overall economy, also means that the government must operate with a smaller tax base than it would otherwise. This limits the government's ability to spend money on the infrastructure vital for a developing country.

A political plus
Felipe Calderon, a Harvard-educated conservative, took over as Mexico's president in late 2006. Having defeated a left-wing opponent, Calderon now intends to continue running the economy with free-market policies, a move investors consider positive.

The political scene has often changed quickly in Mexico and there's no guarantee that this pattern won't repeat itself. In the past, Mexico has experienced boom-and-bust cycles every six years or so. Even though Calderon is coming into office in a period of stable economic growth -- 2006's growth was the highest since 2000, and the Treasury predicts 3.6% growth in 2007 -- he still faces many challenges.

As the United States' neighbor, Mexico benefits from easy access to the world's largest economy. This proximity makes Mexico highly dependent upon the U.S., which limits the diversification benefits of investment in its stocks. EWW's attempts to include more globally based stocks help to alleviate this weakness.

However, EWW remains a highly concentrated fund, with nearly one-quarter of its assets in a single stock and half the fund comprising only a handful of securities. Relying on so limited a selection of stocks increases the fund's potential risk.

Eagle, snake, or cactus?
EWW's 2006 returns were spectacular, but this fund holds many risks for investors, and there's no guarantee that its future returns will remain so outstanding. Consistently high oil prices and positive economic performance in its northern neighbor should help Mexico continue to grow at a decent pace. If Mexico's new administration manages the economy as smoothly as the last couple of presidents have, this country will continue to grow, and an investment in EWW could pay off.

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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or stocks mentioned in this article. Cemex is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.