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There was a time when it was believed by many that Brazil would play a major role in a global economic recovery, and definitely drive South America higher. But this conviction took a beating with this emerging economy buckling under dual pressure of slower growth and heightened inflation.

While inflation stands at 6.70% in June 2013, many fear a stage of stagflation in the short term. Additionally, Brazil’s equity market has underperformed over the last two and half years, leaving many gloomy over the nation’s prospects.

What Happened in Brazil?

Slower growth and higher inflation generally result in an strange situation in which measures adopted to tame inflation will halt growth and vice versa. In Brazil’s case, this is what has happened.

Inflation is now above the ceiling of the nation's inflation-targeting band, forcing policy actions to curtail price increases. To chase inflation, the nation‘s central bank hiked their important Selic rate by 50 bps to 8%, likely hurting growth in the process.

While much of the developing world like Europe, Australia, and South Korea, and major emerging countries such as India, Thailand and Turkey are cutting rates to trigger economic growth , Brazil’s step came as an utter shock (read: 3 Emerging Market ETFs Still Going Strong).

Secondly, the credit worthiness of Brazil has also been wobbling. The country's government debt/GDP and interest payments/revenue ratios have been increasing. An easy fiscal and monetary policy has continuously pressurized the government’s debt profile.

Following such a concern, S&P downgraded the nation’s credit rating outlook to negative from stable in June 2013. The S&P has also warned that rising inflationary pressure, increasing debt burden and a worsening fiscal situation may compel yet another downgrade in the next two years. The rating agency expects the country’s GDP to grow a modest 2.5% this year after growing 2.7% in 2011 and 0.9% in 2012.

Thirdly, the Brazilian real has been losing strength, further adding to the country’s woes. In early July, the Brazilian real marked its biggest drop against the dollar in more than four years. The real has depreciated more than 10% against the dollar since the beginning of the year (Read: Forget Brazil ETFs, Focus on This Top Ranked Fund Instead).

If these factors were not enough, huge social unrest owing to some austerity measures implemented in the country raises serious concern among investors. This is especially true as Brazil is hosting FIFA World Cup in 2014 and the Summer Olympics in 2016.

Both the national efforts demand huge investments towards infrastructure development, blowing up budgetary concerns (Read: Brazil ETFs Surge, But Can It Last?). On account of their worries, Brazilians have since been protesting across the nation, further adding to concerns over stability in the country.

ETF Impact

Following a host of bad news on Brazil, The ultra-popular MSCI Brazil Index Fund (EWZ - ETF report) lost 22% in the first seven months of the year. The relatively less popular Market Vectors Brazil Small-Cap ETF (BRF - ETF report) and iShares MSCI Brazil Small Cap Index (EWZS) shed 27% and 24% respectively in the said period.  

We are maintaining our sell recommendation on most Brazil ETFs. As a result, investors who are bearish on Brazil right now, definitely for a valid reason, may consider a near-term short on the space.

Fortunately, ETFs offer several options to investors to accomplish this task. Below, we highlight a few of the options in the inverse ETF space. These ETFs make a profit when the Brazilian stocks decline and are suitable for hedging purposes against the fall of these stocks (Read: Guide to the 10 Most Popular Leveraged Inverse ETFs).

Direxion Daily Brazil Bear 3X Shares (BRZS - ETF report)

This leveraged ETF was launched in May this year by Direxion which is a key player in the leveraged and inverse leveraged ETF market (Read: Direxion Launches 2 Leveraged Bear ETFs). 

This new ETF seeks to triple the inverse performance of the MSCI Brazil 25/50 Index on a daily basis. The approach results in a focus on mid and large cap Brazilian companies.

The product has amassed over $3.3 million in AUM while volume is light (nearly 3,000 shares), suggesting additional potential costs in the form of wide bid/ask spread beyond the expense ratio of 0.95%.

In terms of holdings, financials takes the top spot, comprising nearly 28% of the total. Beyond that, three more sectors have double digit allocations including consumer staples, materials and energy.

The return from BRZS skyrocketed 64.7% since its inception and investors could book more profits off this fund if Brazil continues to struggle.

ProShares UltraShort MSCI Brazil Capped (BZQ - ETF report)

The fund seeks to deliver twice (2x or 200%) the inverse return of the daily performance of the MSCI Brazil Index. This benchmark holds about 79 stocks in its basket, spreading out exposure quite nicely among the various sub-sectors. Here also, financials are given the top priority with about 27% exposure followed by Consumer Non-cyclical (24.4%), Basic Materials (16.6%), and Energy (11.5%).

The product has $15.9 million in AUM and average trading volume of nearly 4,000 shares per day. This product also charges 95 basis points a year in fees, putting it in line with others in the space. However, contrary to BRZS, this fund is mainly focused to large caps (see more in the Zacks ETF Center).

The fund was one of the best bearish emerging markets ETFs in the second quarter. The fund has also returned a gigantic 52.2% so far this year.  

Bottom Line

While both BRZS and BZQ could be enticing options to play the downtrend in Brazil, BRZS could be more volatile than BZQ due to the former’s higher exposure to mid and small caps securities as well as triple leverage strategy. Hence, BRZS might see big swings in a short time period.

Also, the daily rebalancing nature of both the ETFs may lead to returns that are not close to the expected long-term performance figures. Thus, these funds should be exclusively used by short term traders, though returns could be great for these products if bearish trends continue in Brazil.

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