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This year, Russia has been through quite a brutal stretch. Constant tussles with the West over the Ukrainian issue put the nation’s economy at risk. The crisis dates back to March 16, when over 96% of the Crimean population (an erstwhile Ukrainian territory) voted to be a part of Russia.

The referendum was the result of a more than four-month-long period of unrest between Russia and Ukraine which the West viewed as an utter violation of international law. In protest, the U.S. and the European Union (EU) initially imposed minor bans on some Russian diplomats.

However, in July, the U.S. launched sanctions against Russia’s all-important energy, banking and defense sectors, with the European Union and Canada also introducing similar types of sanctions.

As a result, almost after six months of hostility, Russia counteracted by imposing restrictions on a good number of food imports from the West on August 7.

Russia underwent a flurry of downgrades from big rating agencies like S&P and Fitch since all these geo-political drama started to take center stage. In a nutshell, Russia gave investors every reason to be worried about the nation going forward.

Growth Outlook in Jeopardy

Russia was once a hot FDI destination but the country lost its appeal as a valuable investment proposition over the years, thanks mainly to its slowing growth rate. The Russian economy expanded 1.3% last year. The growth was considerably lower than 4.3% recorded two years ago.

Gross domestic product grew only 0.8% in the second quarter of 2014 representing the slowest rate in five quarters, per Bloomberg. The number fell short of Russia's economy ministry’s forecast for 1.2% growth and 0.9% growth attained in the first quarter. The government now expects the economy to advance 0.5% this year, recording the slowest pace since the recession in 2009.

Consumer demand remained fragile with retail sales slowing for the third successive month in June. Real wage growth plunged to the lowest level in 3.5 years. Investment was sluggish thanks to the soured business mood after the cold-war with the West aggravated.

Inflation & Interest Rate Inching Up

Russia suffers from a common woe of emerging markets – higher inflation. Though the rate fell slightly to 7.5% in July, Russian annual consumer prices flared up for the fifth consecutive month in June to reach almost 3-year highs. The Russian currency, ruble, fell about 12% to reflect the bearish trend.

As a result, the Russian central bank raised its key interest rate thrice since March to contain the plunge in the ruble and tackle inflationary woes. In aggregate, interest rates increased 250 bps since March to attain an 8% mark.

Now that Russia has forged a one-year ban on Food imports, inflation will likely take another leap. Russia’s big cities count heavily on food sourced mainly from Europe. Foreign-grown food satisfies 60% to 70% of total demand in the big cities, and in 2013, the EU sold agricultural goods worth 11.8 billion euros ($15.8 billion) to Russia, while the U.S. exported $1.3 billion in food items.

So, if food inflation starts to creep up thanks to a shortage in food products, the Russian central bank may finally end up hiking the key rate yet again thus giving another blow to the growth profile. The crux of the discussion is that even if Russia escapes a recession this year, the economy will be close to a gridlock.

To add to this, poor demographics and complicated legal framework are crippling the nation’s long-term growth potential thus prompting foreign investors to flee the country. Bloomberg has indicated a 50% chance of Russia’s $2 trillion economy slipping into a recession.

Is There Any Hope?

Though Russia hit headlines this year for all the wrong reasons, investors should note that the nation is commodity rich with plenty of oil and coal reserves. The country boasts the maximum natural gas reserve, implying that it has the power to stop meeting the West’s energy requirement should it threaten severing further economic ties with the former (read: 3 Commodity ETFs Surging on Russia Sanctions).

Notably, Europe imports about 40% of its energy requirements from Russia. Though European leaders are diligently planning to broaden their horizons of energy supplies, a lackluster economic backdrop may restrain Europe from taking some drastic measures against Russia.

Though Russia suffered a cut in credit rating early this year, investors should note that Russia’s government debt to GDP ratio was 13.41% in 2013 – the best among the BRIC nations (read: Russia ETFs in Focus on Credit Downgrade, Rate Hike).

Some still believe that the financing world may be pressed by the series of sanctions and Russian companies will cut their dividend profile marring their appeal among foreign investors. However, the bullish case scenario entails the fact that Russian companies still have a pretty decent financial profile and the government is also liquid enough to pay off its debt in the coming years.

Last year, Russia survived from the emerging market downturn in the wake of taper talk as the nation still has a current account surplus unlike several other emerging nations including India, Indonesia and Brazil. Since the initiation of taper talks, the biggest Russia ETF – Market Vectors Russia ETF (RSX - ETF report) gained about 6.4% in 2013 while broader emerging market ETF iShares MSCI Emerging Markets (EEM - ETF report) lost about 2% (read: Russia ETFs: Immune to Emerging Market Weakness?).

Some believe that tensions might go lower in the coming days as Russia has recently sent humanitarian aid to Ukraine’s war-ravaged east. The aid will reach Ukraine with the support of the Red Cross. Though this signals a remote possibility of an end to the long-stretched scuffle, tension spiked the very next day when Ukrainian forces confirmed the destruction of a part of Russian military convoy in the Ukrainian territory.

Foreign ministers from Russia, Ukraine, Germany, and France recently met in Berlin to talk about a truce between Russia and Ukraine. As of August 18, Russia's Foreign Ministry indicated some improvement on this front.

Market Impact

Given the geo-politics, the Russian market’s heavy correlation with the price of oil, dirt-cheap valuation of Russian equities, sluggish growth but fundamentally sound fiscal structure, a play on Russia could make sense for those with high risk tolerance. We have highlighted some of the key ETFs in this space.

Market Vectors Russia ETF (RSX - ETF report)

For investors seeking the biggest and most liquid option in the Russia ETF world, RSX comes across as the best choice. The product trades about 6.1 million shares a day and invests $1.5 billion in assets in 49 holdings. This suggests tight bid ask spread for pretty much all investors.

In terms of sectors, energy dominates with nearly two-fifth of the total portfolio and is closely followed by the materials sector which accounts for another quarter of assets. RSX has a net expense ratio of 63 basis points a year and has slumped by 12.5% year-to-date; presenting investors with huge bargains at current valuation levels. Notably, RSX is trading at a P/E (ttm) of six which is half of what EEM traded as of August 13.

iShares MSCI Russia Capped Index Fund (ERUS - ETF report)

ERUS follows the MSCI Russia 25/50 Index. This index produces a fund that holds 23 securities and has a heavy concentration on the top three companies which make up nearly 41% of total assets. Additionally, energy firms make up nearly 48% of total assets in ERUS while the next biggest sector, financials, occupies around 15% share.

ERUS, which charges investors 61 basis points a year for its services, has amassed about $280 million in assets. The fund has shed about 11.7% so far this year (read: Beyond Russia: How are Eastern Europe ETFs Performing?).

Market Vectors Russia Small-Cap ETF (RSXJ - ETF report)

For investors looking for a small cap play on the Russian economy, RSXJ represents a solid choice. The fund tracks an index of about 24 companies that are either domiciled in Russia or generate a substantial portion of their revenues in the country. 

This product follows a rather spread-out approach as RSXJ puts only 17.5% of its assets in materials firms, 17.1% in energy and 15.8% in industrials. The product charges investors a net expense ratio of 67 basis points a year.  RSXJ has amassed about $52.9 million so far and trades in a paltry volume.

However, this pint-sized fund has massively underperformed its large cap counterparts and has lost about 23% so far this year.

Daily Russia Bear 3x Shares (RUSS - ETF report)

Investors giving more importance to geo-politics should be aware of the bear fund on Russia as only this option will earn them some return in times of adversity. RUSS is a triple leverage inverse equity fund of Russia. The fund has so far generated $28.9 million in assets. RUSS charges 95 bps in fees and has gained about 16.6% to date.

Bottom Line

At this stage, Russian equities just need a kick to skyrocket higher. Stocks are trading at extremely cheap valuations. Any improvement in geo-politics will take the markets to multi-month highs.

So, investors seeking to enter this market should closely follow political releases. Russia’s future performance will hardly reflect economics. Geo-politics will be the sum and substance of the Russian story, at least for the near term.

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