beyondbrics

Like Russia for its domestic growth potential? But how to invest? Russia’s big companies are dominated by energy and minerals groups which are, in essence. plays on global commodity prices. The answer lies in smaller domestically-oriented companies. But for international investors small caps can be tricky and time-consuming investments to manage.

Van Eck Global, the US fund manager, has a solution – a new exchange traded fund providing exposure to smaller Russian companies.

Russian ETFs have been able attract substantial inflows in 2011 at at time when investors have been making big withdrawals from broad emerging markets ETFs.

Russian ETFs gathered $2.4bn in new cash in the first three months of 2011, already well ahead of the $1.9bn of inflows registered for the whole of 2010. (BlackRock data).

This is notable as it comes at a time when investors have withdrawn almost $10bn (actually $9.6bn) from broad emerging market focused ETFs. Analysts think investors are starting to make more allocations based on the attractions of specific countries rather than simply looking for broad emerging markets’ EM exposures. Russia focused ETFs have been the biggest beneficiary of this shift, attracting more inflows this year than any other individual emerging market.

The existing Van Eck Russia ETF with its focus on larger companies has won a large chunk of this year’s inflows into Russian ETFs. Known by its ticker RSX, it has attracted almost $1bn (actually $995m) in the first three months this year compared with $836m for the whole of 2010.

Helped by strong gains for the Russian stock market, assets held in RSX have more than doubled over the past twelve months to reach reached $3.9bn. (Data from the National Stock Exchange)

So the rationale for Van Eck to strike while the iron is hot by launching another Russian ETF seems clear enough but will it appeal to investors?

Van Eck’s bosses are clearly hoping that the fundamentals supporting Russia’s stock market will attract investors to its new small cap Russia ETF.

Van Eck points out that Russia’s stock market is trading on a forward price earnings ratio of about 7.1x, a big valuation discount to other Bric countries and to a broad emerging markets benchmark where the forward PE is currently around 11.4x. The valuation discount applied to Russia’s stock market is longstanding and reflects international investors concerns about corruption, corporate governance standards, the country’s over-dependence on the oil sector and possible political instability.

Van Eck notes that while large-cap focused Russian ETFs will contain global companies with significant exposure to sectors of the economy which have been deemed strategic by the Russian government, particularly energy, this leaves the domestic consumer story largely untouched.

“The best way to gain a pure-play exposure to a country’s domestic economy is through smaller companies that derive their revenue primarily from doing business locally,” said Ed Kuczma, emerging markets analyst with Van Eck.

“Other potential advantages with small caps generally include less political interference, relatively better corporate governance practices, and relatively better protection for minority shareholder interests.”

However,while it may well be that smaller companies attract less political attention, it is not obvious why investors should expect better corporate governance practices from smaller companies in Russia or indeed better protection for minority shareholders.

Van Eck has imposed minimum size and liquidity requirements on the constituents of its new ETF. However, bid and ask spreads on smaller companies are almost always wider than for their larger counterparts. This makes trading in smaller cap stocks less efficient (more expensive) and it can also lead to a higher tracking error for an ETF.

Van Eck also uses proprietary indices as the underlying benchmark for its small cap ETFs which allows it to invest in companies which are listed in developed markets as long as they generate a significant proportion of their revenues from the local market. So the Russia small cap ETFs will invest in Petropavlosk, the gold miner, ITE group, an exhibitions company specialising in emerging markets and Heritage Oil, which are all listed in London. This should help lower trading costs in some of the companies included in the ETF but whether it will have a substantial impact on the overall efficiency of the ETF remains unclear.

Another point that investors might want to note is that although small cap stocks should outperform their larger peers over the longer term, they have already enjoyed a very strong run in Russia. Over the past two year, small Russian stocks have surged almost 300 per cent compared with a rise of around 111 per cent for the main market. (MSCI indices in $ terms). So the market has already priced in a lot of good news.

Van Eck has three other small cap emerging markets ETFs and these have struggled to attract inflows this year. The Latin America small cap ETF has attracted just $3m this year and remains a tiny fund with assets of just $28m. The India small cap ETF has done slightly better with inflows of $10m but its assets also remain small at just $55m. Meanwhile, the Brazil small cap which does have fairly substantial assets of $942m has seen outflows of $102m so far this year.

So appetite for these small cap focused ETFs has been patchy at best and the still uncertain outlook for Russian’s stock market would suggest that the new Van Eck ETF could also struggle to gain traction with investors.

Related reading
EM equities small is beautiful, beyondbrics
Oil windfall gains still to come for Russia, beyondbrics
Oil price no panacea for Russia, beyondbrics