The Brazilian capital markets are among the most sophisticated in the world. During periods of hyperinflation in the 1980s and 1990s, market participants adopted highly complex financial instruments for hedging and protecting returns. Over the past 25 years, as the country went through several boom-to-bust cycles and suffered a profound deindustrialization, Brazil has increasingly become a FIRE economy, driven by Finance, Insurance and Real Estate. During this period, Brazil’s best and brightest have flocked to financial jobs where salaries are multiples of those available in more productive sectors. At the same time, a steady rate of consolidation in most financial activities has led to a few preeminent dominant firms with strong pricing power and high profitability.
The incumbents – mainly, large dominant banks — over time may have become vulnerable to new entrants that introduce disruptive models and more efficient cost structures. A wave of new fintech firms have taken advantage of abundant global venture capital funding to take on the incumbents with new business models. At the forefront of these there is XP, a Brazilian brokerage firm/financial advisor, which is currently in the process of launching an IPO on Nasdaq. Founded in 2001 by Guilherme Benchimol, XP is probably the best Brazilian entrepreneurial success story of this generation. Influenced by the philosophy of Brazil’s Jorge Paulo Lehman (3G/Inbev) and by American discount brokers such as Charles Schwab, Benchimol created a financial service platform which aims to democratize finance in Brazil and disrupt the entrenched incumbents (e.g., Banco Itau and Banco Bradesco). Benchimol has largely achieved his goal and XP is now a major force in Brazil’s financial sector, with 1.4 million clients. The IPO’s bank underwriters are looking for a valuation of BRL 60 billion (USD 15 billion), about half that of banking behemoth Bradesco.
Ironically, XP’s huge success may have now turned it into somewhat of an incumbent. Though much of the IPO prospectus extols how well positioned XP is to exploit the inefficiencies of the investment industry, a look at the details paints a different picture.
XP’s most profound innovation has been its open platform, which allows it to provide a financial supermarket of products, in contrast to the “walled-gardens” historically preferred by the big banks. It has exploited this advantage with technological and marketing savvy. But, the one thing it hasn’t really done is attack the very high fee structures that characterize the Brazilian asset-management industry. In fact, XP has become the biggest distributor of the independent asset management industry and benefits from the juicy distribution fees that fund managers pay to raise assets.
The problem is that the Brazilian asset management industry today is an aberration in terms of the fees that investors pay for investment products, with 1% management fees common for bond funds and 3% (including prevalent performance fees) common for equity funds. These kind of fee structures exist in Brazil only because of the powerful pricing power enjoyed by the large banks.
The persistence of high fund management fees in Brazil is justified by the claim that the domestic markets are highly inefficient and present abundant market “alpha” (returns above those available from the market) to be harvested by active managers.
However, evidence of this market inefficiency is scarce. One might expect “alpha” to be available for professional investors in markets that are dominated by retail investors (e.g. China, India, Turkey), but Brazil is a market trafficked predominantly by sophisticated and highly-paid professional investors. Also, most funds in Brazil invest in a very narrow cohort of some 100 stocks which are very closely followed by competent analysts; most funds are also short-term oriented trend followers, with low appetites for small and less liquid stocks.
The best analysis of the Brazilian domestic funds market is done by S&P Dow Jones Indices (Latin America Scorecard, SPIVA). A summary of the latest review (through 2018) below shows how difficult it is for funds in Brazil to generate alpha, particularly in bonds, where 100% of funds underperform the benchmark. In equities, about 85% of Brazilian funds underperform the index for 3,5,and 10 year periods. Most likely, this is a consequence of the combination of market efficiency and very high fee structures.
Ironically, XP, to a degree, may be more vulnerable than the incumbents it purports to undermine. XP’s earnings stream relies heavily on brokerage revenues and fund distribution fees, which represent only a small part of the highly diversified revenues stream enjoyed by its competitors. These fees are high today, supported by the large inefficiencies of the Brazilian financial sector but these are now ripe to be disrupted by innovation. Of late, we have seen some of the incumbents slashing commissions, following in the foot-steps of the U.S. industry.
Also, Bradesco and Itau have taken the plunge and launched U.S.-style low cost ETFs.
If the name of the game is raising assets, the future in Brazil looks like the U.S, with a heavy presence of systematically managed passive products, both in the form of ETFs and mutual funds. This is not a space where XP, in its current form, will prosper. So, it’s not surprising to see the budding ETF space in Brazil dominated by Itau, Bradesco and Blackrock’s Ishares.
In fact, a U.S. style transition to passive products is in full swing in the Brazil domestic market. Blackrock’s Ishares Bovespa ETF (BOVA11) has raised USD2.3 billion in Brazil. As the chart below shows, volumes are exploding. Interestingly, BOVA11 is priced at 30 basis points (.30%) annually, which is about half of the fee charged on its NYSE Brazil Ishares (EWZ). Itau has also launched a Bovespa ETF (BOVV11) for which it also charges 30 bp, and Bradesco has its own Bovespa ETF (BOVB11), with a 20 basis points management fee (currently, the cheapest Brazilian stock market ETF in the U.S. is Franklin’s, with a fee of 19 basis points.) Itau’s ETF undercuts its own Bovespa Index mutual fund, for which it charges an astonishing 2% fee, a reminder of legacy practices.
As we have seen in the U.S., the growth of passive investing is very likely to force a consolidation of the Brazilian asset management industry and a dramatic reduction in the fee structure. Firms like Schwab are now staking their future on asset management and have become leaders in ETF issuance. The same will have important consequence for the fund distribution industry in Brazil, and this may resent a short-term challenge to XP’s talented management.