Investors should always been cautious investing in Russia. Volatility is nothing new for the Russian Market as seen following the famous Russia debt default in the 1990s which brought LTCM to its knees and continuously weak governance and corruption. The 10% one day loss in the Russian market index following annexation of Crimea and intervention in Eastern Ukraine shows volatility can return in a blink of an eye. Is the optimism from the BRIC era truly over? Russian ETF tracking the broader market is the best means for investors taking a contrarian position. It mitigate company specific risk while maintain upside exposure.
Russia Market Index Funds
The two Russian ETFs which broadly tracks the Russian equity market is the Market Vectors Russia ETF (RSX) and iShares MSCI Russia Capped ETF (ERUS). RSX takes the crown as the largest Russia ETF currently available for investors to gain exposure to the Russian markets.
Using RSX as a broader representative of the Russian market. The performance of the Russian ETF for the last 5 years has lagged the S&P 500. The lag in performance is driven by the stalling in oil production volumes, broader European economic crises and domestic macroeconomic risk. This has provided an opportunity for value investors to take advantage of discrepancy between what the stocks in the ETF are worth and the current traded prices.
The decline in RUB/USD post the oil crash of 2014/2015 has not help overall market sentiment.
From Russia with Value
From valuation perspective, the overall market price to earnings ratio measured in US dollar is in the high single digit territory. One interpretation is Investors feels that the risk given the current destabilization in the Eastern Europe warrant the discount to broader Emerging Market peers such as India or China.
From looking at overall undervaluation of the market, investors should choose the right ETF to gain the market exposure. From the breakdown of the ETF investment by sector, the result highlight major differentiating factors between the main Russian ETFs.
While the performance of both RSX and ERUS are heavily reliant on the energy sector with almost 40% of the asset under management for RSX. 55% of the ERUS AUM is invested in the energy sector.
Additionally, RSX is more diversified across more sectors than ERUS. It has material exposure to Industrial, Technology and to an extent consumer cyclicals and Healthcare stocks in Russia.
The Russian stocks in the ETFs are mostly large capitalization stocks. This metric can be misleading as market capitalization assumes all of the outstanding shares are freely traded. Given for most companies only portions of outstanding stocks are are actually free float, the remainder held in the hands of the State or prominent oligarchs this should be taken with grain of salt.
RSK holds almost 40 positions compared to 20 positions in ERUS. From analyzing the top 10 holdings, we can see a degree of concentration risk of RSX and ERUS. Top 10 largest position of RSX accounts for 62% of total AUM, 70% of ERUS AUM. Hence these Russian ETFs are not diversified as you would expect and overall fund performance is reliant on few specific large positions below.
Largest position in both ETF the largest position is the Russian oil giant, Gazprom. 8% of the RSX is allocated to Gazprom. Interestingly ERUS has almost 20% of the fund allocated to Gazprom with another 10% for Lukoil. These 2 positions in ERUS comprise almost 30% of the fund.
The low valuation of Gazprom depresses overall ETF P/E ratio as currently it is trading at 2 times this years earnings. Given the risks investing in Russia, the current low market valuation of Gazprom provides a degree of margin of safety.
Leveraged Russia ETF
Investors that has high risk tolerance can magnify returns through use of leverage ETFs. Direxion has 3x bull (RUSL) and bear (RUSS) Russia ETFs which allows investors to take a position either long or short the market.
We should note that these are synthetic exchange traded funds which means that RUSL and RUSS does not actually hold underlying stocks. Instead equity return swaps are used to take positions on the tracking index.
Risks investing in Russia
Investors should approach both ETFs with caution if a significant portion of the portfolio is allocated to Russian ETFs. The downside side of the heavy reliance on the energy sector is any fall in the crude oil price from current levels could pose additional risk to Russia market as well as the economy. Shorting leveraged oil ETF which tracks crude oil prices can offset any short term price shocks from the fall in crude oil.
Unfortunately there are no inverse Russia ETFs. We can short the above long ETFs to gain similar short exposure to the Russian market.