The BRIC’s economies have been a subject of a lot of debate recently. Emerging market stocks can play an important role in a diversified portfolio as their growth prospects are much higher than those for developed economies. Having said that, there are major risks associated with potentially high returns. As stocks are volatile as compared to bonds, so too are emerging market stocks to the stocks in developed nations. But many forget about this little detail.
To answer this quickly: the stock market is a discounting mechanism and can usually predict the future better than anyone else. In order to explain this, let us take a look at the US SPX index (S&P500;) and compare it with the most liquid of the BRICs ETF’s, which are a good representation of their internal market indexes. In the one and two-year graphs below, we use EWZ for Brazil, FXI for China, INP for india, and RSX for Russia.
By looking briefly at these plots, it clearly shows the high degree of under-performance of these ETF’s when compared to the S&P500.; If an investor is to seek a fundamental explanation for why this has happened, one can outline it quickly as follows:
1- Inflation resurgence in a big scale, causing the governments to raise interest rates, and hence slowing growth;
2- High dependence on investments from abroad as a mean to leverage their consumers and finance domestic companies’ need for capital;
3- Fast growth of these economies can not be matched by their infrastructure needs, which in turn limits activity and generates inflation (this is a special case for Brazil and India);
4- All these economies are still closed, and high tariffs on imported goods does not create a check on their competitiveness and pricing, which causes inflation when demand is high;
5- Dependence on exports for growth (especially China). When consuming economies (like the US) freeze, growth suffers.
There are other factors, but this suffice for now. One could argue that these issues are cyclical and only temporary, like many fund managers do (CNBC anyone?). But we will not be biased here and will offer two alternative low risk strategies (bull and bear) for investors wanting to play emerging market stocks. Like a friend once told me: “Emerging markets are a trade, not a long-term investment.”
BULL on BRICs
The strategy here is basically to “long” (buy) the BRICS ETF’s and to “short” the SPY ETF (SPX/10). Summary: BUY all four BRIC stocks, SHORT SPY.
BEAR on BRICs
The strategy here is basically to “short” the BRICS ETF’s and to “long” (buy) the SPY ETF (SPX divided by 10). Summary: SHORT all four BRIC stocks, BUY SPY.
Here is an example of how it can be done: One can use US$1,000 to BUY/SELL each one of the four BRIC countries (EWZ, FXI, INP, RSX), and US$4,000 to BUY/SELL the SPY. So, in this example, the investor is using US$4,000 “long” and $4,000 “short”.
One can scale this down or up depending on risk appetite and margin requirements. One can also use options but we will not cover this alternative here, as the vast majority of traders do stocks only, and it is less complicated.
The profit and loss from this strategy will be determined by the DIVERGENCE/ CONVERGENCE of the position. A pair trade like this offers controlled risk, low correlation to the market averages and ability to generate alpha in up or down markets.
This article was written by Tom Elias exclusively to BrazilianBubble.com. Mr. Elias is an investment professional and business consultant with 30-years of high-tech and manufacturing experience in Brazil and the U.S. The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. To contact him, please write an email to firstname.lastname@example.org