Brazil investors look beyond benchmark index A funny thing happened to Brazil's benchmark Bovespa index this month. OGX Petróleo e Gas, the oil company controlled by the country's richest man, Eike Batista, has been one of the market's most notorious losers, shedding about 87 per cent of its value over the past year to become a penny stock in dollar terms. Its reward for this unruly behaviour? A greater weighting in Brazil's Bovespa. Indeed, the oil explorer and producer is one of the five stocks with the heaviest weighting in the index, joining much more venerable, although also underperforming, names such as Vale, the world's largest iron ore exporter, and Petrobras, the national oil company. The reason for this anomaly is that the Bovespa is one of the few large indices heavily weighted according to liquidity as well as market capitalisation, meaning the most volatile stocks often sit higher in the index than they would otherwise. "It's perverse," says Oliver Leyland of Mirae Asset Global Investments, a fund manager that has some locally domiciled funds benchmarked against the Bovespa. The skewed nature of the Bovespa contributes to what has increasingly become a two-tiered approach to the Brazilian market by investors. On the one hand, there are the out-of-favour sectors that dominate the Bovespa, such as oil and mining, and those that have been hit by government regulatory moves, such as finance and utilities. Then there are all the other companies, many of which are hugely popular for their exposure to Brazil's more buoyant consumer sectors, such as education and retail. "What is expensive is becoming more expensive all the time," says Carlos Constantini, head of equities research at Itaú BBA, of the more popular sectors. The so-called "quality" Brazil, those stocks considered to still have high-growth prospects coupled with reasonable governance and liquidity, is trading at 25 times forward prices to earnings, he says. Those sectors out of favour, utilities, steel, finance, oil and mining, as represented by the Bovespa, are trading at only about nine times forward earnings. The rest are in between. The curious nature of the index is summed up by OGX, which has a 5.06 per cent weighting with a market capitalisation of R$4.9bn compared with Brazil's highly successful beer company, Ambev, which has a weighting of just 1.62 per cent in spite of having more than 25 times the market capitalisation at R$261.6bn. BM&F Bovespa, the company that runs the market, does offer other indices, including more conventionally calculated instruments based on market capitalisation and free float. And analysts say the inclusion of liquidity into the Bovespa was to ensure the index did not simply track the movements of the two giants, Petrobras and Vale. International fund managers also tend to track other indices, such as the MSCI group. But as the benchmark, the Bovespa does cause problems for fund managers that have to track it and that do not want to invest in volatile stocks. Aside from OGX, these include construction companies, such as PDG Realty, which with a capitalisation of only R$3.3bn is capable of moving the market. "You end up taking a pretty active bet on a stock which you don't own and you are not necessarily likely to own," says Mr Leyland of Mirae. He says this can contribute to "tracking error" - variation of performance away from the benchmark index, in passive funds. Still, the two-tiered market is also becoming a selling point for many fund managers. Brazil's Bradesco Asset Management has recently registered in the US to sell Brazil funds and already has overseas operations in places such as Luxembourg. One of its key strategies is to sell funds that have nothing to do with the Bovespa, such as those focusing on small and medium-sized companies. Stocks such as Kroton Educacional, a private university group that will be the world's largest by market capitalisation once it completes a merger with a rival, Anhanguera, has gained 120 per cent over the past year. It does not feature in the Bovespa. "Our idea is to bring to foreign investors strategies that are away from the Bovespa or MSCI indices," says Joaquim Levy, chief executive of Bradesco, which has R$288bn in assets under management. For now, even these alternative strategies are harder sells given falls in the Bovespa, which is down 10.36 per cent this year. Investors are switching either to Mexico or avoiding some major emerging markets altogether. But Itaú"s Mr Constantini believes the Brazilian long-term structural story remains intact, particularly in the consumer and infrastructure sectors, and investors will return once Mexico begins to look overpriced. "We have already started to advise some rotation back to some names in Brazil," he says.