* Major funds were underweight Mexico, had favored Brazil
* Currency movements helped dollar-based investors in Mexico
* Mobius-run fund underperformed; had big Brazil weighting
* Federated's InterContinental Fund had big Mexican bet
BOSTON, Jan 2 (Reuters) - The two biggest financial markets in Latin America swapped their long-held roles in 2012, with Mexico surging ahead and Brazil lagging, catching many U.S. fund investors in the region off guard.
Stocks in Brazil, which had benefited over the past decade from a fast-growing consumer class and Chinese buying of commodities, suffered as the government increased regulation of key sectors of the economy and Asian demand waned. In the third quarter of 2012, Brazil's economy grew only 0.9 percent from a year earlier, while Mexican growth was 3.3 percent.
Mexico's fortunes rose partly because of its closer ties to modest U.S. growth and hopes the new Mexican government will undertake major reforms that could boost the economy.
"This time last year most folks were quite positive on Brazil and it was quite a crowded trade," said Adam Kutas, manager of Fidelity's Latin America fund. "Mexico had underperformed in the region for eight or 10 years, so it was under-owned."
The stock market moves were magnified for U.S. investors by Mexico's strengthening peso and weakness in Brazil's real. In debt markets, Mexico also outperformed its bigger cousin.
By year end, the MSCI Brazil Index lost 3.5 percent in dollar terms while the MSCI Mexico index climbed 27.1 percent. Colombian stocks also posted big gains, rising 31.6 percent, while Chilean equities lagged, with a 5.6 percent advance.
One of the best-known funds that over-weighted Brazil was Mark Mobius' $2.3 billion Templeton Developing Markets Trust , with almost 21 percent of its assets in Brazilian stocks at the beginning of 2012, its biggest bet on any single country. Mexican stocks comprised just 1.5 percent of the fund.
It rose 13.1 percent, trailing 83 percent of diversified emerging market funds, which gained over 18 percent on average, according to Morningstar. Mobius' big bets on China also undermined his performance in 2012. [ID: nL4N09T3PI]
Mobius' stock picks from Brazil were a mixed bag as bank Itau Unibanco Holding lost 9 percent and mining giant Vale SA gained just 6 percent. But tobacco company Souza Cruz jumped 38 percent and beverage maker Companhia de Bebidas das Americas gained 57 percent.
The fund has a three to five-year investment horizon, Mobius said in an e-mail. "Brazil is an area that we continue to believe has good long-term potential," he wrote.
The larger Wells Fargo Advantage Emerging Markets Equity Fund, at more than $3 billion, underperformed. It also bet big on Brazilian stocks like Petroleo Brasileiro S.A., which lost 13 percent, and Vale. But another top pick, Banco Bradesco SA, gained 17 percent.
The fund gained 12.5 percent for the year, trailing 87 percent of its peers, according to Morningstar. Wells Fargo declined to comment.
Even among funds that specialize in Latin American stocks, the largest actively managed funds had a rough year and trailed the category's average 12.3 percent gain, according to data from Lipper, a unit of Thomson Reuters. Fidelity's $2.3 billion Latin America fund gained just 4.1 percent, BlackRock's $566 million fund rose 8.7 percent and the $1.7 billion T.Rowe Price fund added 10.3 percent.
Federated's InterContinental Fund, with stocks in both developing and developed markets outside the United States, was one of the big winners in getting Latin America right.
Entering 2012, it had a big bet on Mexican stocks, about 13 percent of the fund, including bank Grupo Financiero Banorte , beverage group Fomento Economico Mexicano and broadcaster Grupo Televisa. Banorte shares doubled, Fomento gained 46 percent and Televisa 16 percent. That helped the fund gain 20.2 percent for the year, beating 85 percent of similar funds, according to Morningstar.
Now Federated is building its stake in Brazil. "It's a contrarian call for LatAm watchers to be adding Brazil," said Geoffrey Pazzanese, one of the fund's co-managers. The country is spending more on infrastructure projects and should soon show signs of renewed growth, he said.
Mexican stocks have clearly become more expensive, but Federated still expects solid returns in 2013. President Enrique Pena Nieto is expected to bolster the economy by overhauling the country's tax regime and shaking up state-run oil giant company Pemex. [ID: nL1E8NB0DM]
Federated still favors Banorte, which could show 25 percent earnings growth in 2013, P azzanese said. "Mexico is under-banked," he said. "The potential for growth is strong."
Another favorite is auto parts maker ALFA, one of the only ways to invest directly in the growing auto sector.
Fidelity manager Kutas said he is sticking with his big bet on mobile telecommunications growth. The fund's top holding as of the end of October was Mexican telecom operator America Movil SAB, which lost 4.3 percent in 2012.
"The sector continues to morph and change from pure voice-driven providers to something more," Kutas said, though he sees the play taking time. "Data growth and smart phone adoption are slow and the average investor may not be patient enough."
SAME CURRENCY STORY
The Brazil-Mexico rivalry also played out in the currency markets, where Mexico's peso gained on the U.S. dollar and Brazil's real declined. The dollar gained almost 10 percent on the real, which traded at around 2.0475 per dollar at the end of 2012. But the dollar lost more than 7 percent to the Mexican currency, which closed the year at around 12.8747 per dollar.
Demand for pesos increased as investors flocked to Mexico's relatively higher-yielding debt. The real was hurt as Brazil's central bank repeatedly cut rates to stimulate the economy.
The moves magnified the difference in returns for U.S.-based investors. In local currency terms, Mexico's IPC stock index rose nearly 18 percent, while Brazil's Bovespa gained just over 7 percent due to a late rally in December.
Aberdeen Asset Management was among those betting on the peso and Mexican bonds. The firm's Emerging Markets Debt Local Currency Fund gained 15.9 percent in 2012, and the peso bet continues into 2013.
"If there is a single favorite country for us, it's Mexico," said co-manager Edwin Gutierrez. He, too, cited expected reforms to boost growth. "The initial signs are hopeful," he said.
Mexico's ample foreign currency reserves and IMF credit line should also help, said Esteban Velásquez, head of market analysis for Allianz Fondika in Mexico City. "If we add the fact that the famous reforms, so needed by this country, are 'round the corner, we may even see the credit ratings agencies take another positive look at Mexico."
Colombia's peso gained even more than Mexico's -- almost 9 percent in 2012. Foreign investment, particularly in energy and mining, returned to Colombia last year as the government pushed rebels out of large areas of the country.
The currencies of Chile and Peru also did better than expected. At the onset of 2012, analysts posited that Chile's peso would gain almost 4 percent. But the peso strengthened about 8 percent on strong economic growth and firm prices for its top export, copper.
Peru's currency, the sol gained more than 5 percent last year to 2.55. (Reporting by Aaron Pressman with additional reporting by Gabriel Stargardter, Jean Luis Arce and Lorena Segura in Mexico City; Guillermo Parra-Bernal and Asher Levine in Sao Paulo; Anthony Esposito in Santiago; and Terry Wade in Lima.; Editing by Martin Howell and Dan Grebler)