Latin American Guerilla: The Brazil ETF

Like Carnival time, which returns every year to thrill millions of Brazilians, the iShares MSCI Brazil Index Fund (NYSE:EWZ) has pleased many investors lately. With returns of more than 30% for each of the last four years, it's hard to find something wrong with this fund. In 2006 alone, the fund was up 44%, and halfway through 2007, it's still one of the top-performing country ETFs. For investors who want to try to discern the future outlook for the fund, it might help to look at the Brazilian economy, the largest in Latin America and the 800-pound gorilla in that region.

Economic growth
Brazil is considered a developing country, so some of its major export products might come as a surprise, since they include aircraft, steel, and autos. Still, a large part of the credit for Brazil's stock market growth is due to the commodity boom, which, for Brazil, primarily means coffee, soybeans, orange juice, and ethanol. Although Brazil's exports are booming, the country's 3.3% quarterly average growth rate over the last five years is low for a developing country.

Structural weaknesses
Brazil suffers from a weak physical and intellectual infrastructure. Public institutions are widely regarded as inefficient, and civil servants are bureaucratic. In addition, the federal government has difficulty controlling its spending, and corruption and red tape are endemic. Finally, even though Brazil is a democracy, when it comes to politics, the country suffers from weak parties that have been unable to create solid coalitions. This fractured leadership means less ability or willingness to make the reforms necessary to streamline the economy.

To compete and surpass other emerging markets, Brazil needs to spend more on infrastructure projects and increase education standards. It also needs to reduce its high tax burden, restrictive regulations, and corruption. Even marginal changes in these areas could cause Brazil's growth rate to spike.

Moving forward
Brazil has roughly the 10th-largest economy in the world, which makes it a South American powerhouse. The country's economy expanded 4.3% in the first quarter of 2007 and showed signs of accelerating growth.

Since the mid-1990s, Brazil has made some major macroeconomic changes, such as taming hyperinflation, which at one point reached 80% a month. The country is now working on tax reform aimed at unifying the value-added tax. Falling interest rates and an appreciating currency are several other positive trends for Brazil this year.

Until country ETFs came along, investors who sought country-specific exposure were subject to high trading costs and fees of 2% or more for mutual funds. The iShares MSCI Brazil Index Fund changed the playing field significantly, coming in with an extremely competitive 0.70% expense ratio. The fund has shined for most of its seven-year history. Whether or not that continues will most likely depend on overall trends affecting commodities, but also on specific issues affecting Brazil, such as infrastructure spending.