ETFs - trouble for Russia?

Emerging markets are hot—partially because they have rebounded strongly from the global stock market meltdown in 2008. After ignoring the rise of the fast economies for much of the 1990s, mainstream investors have woken up to the huge gains that can be earned in a relatively short amount of time from these markets, and have turned to the exchange-traded fund (ETF) as their vehicle of choice. However, long-term investors into the biggest emerging markets warn that these funds are effectively “hot money” and can destabilize the fastest-growing stock markets. Russia’s stock market has been the star performer this year, but as the economy is increasingly dependent on oil, analysts worry that the increased importance of ETFs means any correction could be sudden and sharp.

The appeal of ETFs is that, unlike a mutual fund, these funds are traded on an exchange and can be traded like a stock. That means investors can get in and out of a fund instantly. But, like a mutual fund, the underlying fund is based on a basket of stocks that give the diversity that is the cornerstone of any long-term investment into a risky asset class. They also have low costs and a beneficial tax status.

“In many ways, the parallel development of exchange-traded funds and the investment case for emerging markets has been a happy coincidence,” said Chris Weafer, head of strategy at UralSib in Moscow. “ETFs have enjoyed a huge wave of interest from investors wanting to tap into high-growth markets, as they can offer broad exposure or drill down into specific areas.” 

Few would have thought that emerging markets would be beneficiaries of the flight to safety trade, but that is what has happened as developed markets bury themselves in a deep debt hole. Emerging market investments have done very well over the last two years, and Russia’s market has been one of the best performing in the world, up about 150 percent in 2009 and 22 percent in 2010.

Most of the gains in 2010 were made in other emerging markets, but Russia is the best performing BRIC market this year, up 15 percent over the first three months of 2011.

The leading RTS index passed the psychologically important 2,000 mark in March as the valuation of Russian stocks overtook their pre-crisis highs for the first time in two years; the RTS is expected to pass its all-time high of 2,487.92 later this year.

Russia is now attracting considerable overseas cash, and fund tracker EPFR Global says that new money flows into Russia-focused funds in the last week of March amounted to $486 million, up from $139 million the week before. By the end of March, assets under management in Russia-dedicated funds hit a new all-time record high, breaching the $20 billion mark, according to Uralsib. Half of this is now in ETFs.

“ETF investors continue to increase exposure to Russia. Notably, almost all inflows into Russia funds came from country ETFs, which is a continuation of the trend of large inflows into country ETFs, which began late last year,” said Weafer. 

However, thanks to the stock-like nature of ETFs, fund managers say they add to the volatility by acting like “hot money” – highly speculative investments looking for a short-term gains. The point was brought home in the middle of March when all stock markets in all emerging markets experienced a sell-off as developed markets started to showed signs of revival.

“The Russian market is currently standing apart from this trend. As a difficult EM, Russia received a disproportionately low share of the portfolio investment that fled the West following the credit crunch. Having absorbed much less Western hot money, Russia has been less susceptible to the profit-taking and the more general sentiment shift away from EM and back towards the developed world,” said Liam Halligan, chief economist of Prosperity Capital Management, a dedicated Russia fund.

The silver lining in the rise of ETFs is that as a mainstream investment vehicle, the world “Russia” has entered the lexicon of the financial advisors who sell funds to the small investor and the more conservative institutional investor.

“ETF inflows [to Russia] reflect the fact that Russia is now being increasingly cited among mainstream professional investors as a market with good prospects during 2011 and beyond,” said Halligan.

It is an education process that will ultimately benefit everyone, but in the meantime, investors are expecting a choppy ride as worries over turmoil in the Arab world and, subsequently, international oil prices dog fund managers. If the ETFs take fright at falling oil prices, their collective exit could cause a sharp correction in Russian share prices.

“These fund flows are very sensitive to oil and other commodity price trends. That sustains a positive backdrop for Russia and Brazil for now, but increases the risk of greater market volatility when commodity prices stabilize or fall,” said Weafer.

In a worrying early sign, Market Vectors Russia exchange-traded fund, the biggest U.S.-listed Russian ETF, sharply increased its short selling of Russian funds at the end of February, according to Bloomberg. Short sellers sell borrowed shares, hoping to buy them later at a lower price and return them to the lender.

Other investors point to the still-cheap valuations: Russian stock valuations on a price-to-earnings base are the lowest among 21 major emerging markets, according to Bloomberg. “Russia is in pretty good shape at the moment,” said Julian Mayo, a London-based money manager who helps oversee about $3.5 billion in developing nations at Charlemagne Capital Ltd. and has “overweight” holdings. “I think it will continue to outperform.”

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