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The past six months have been an extremely rough time for emerging market equities as fears over a slowdown in foreign locales and general risk aversion have pushed many investors into lower risk securities such as blue chip American stocks. As a result, broad based products like (VWO - ETF report) and (EEM - ETF report) have slumped in the period, tumbling by close to 12.8% in the time frame. Yet these losses pale in comparison to what some experienced in certain emerging nations, and especially in the case of Russia.
The Russian markets have pretty much matched their broad based funds in terms of movements just with significantly more volatility. Thanks to this, and the general slump in the emerging equity world, Russian stocks have lost more than a quarter of their value in the past six month period. As a result, Russian equities could be screaming buys for some shrewd—but volatility tolerant—investors with an eye for developing nations (read Three Overlooked Emerging Market ETFs).
This possible bullish case on Russia could be mainly due to one key factor; the nation’s impressive position in the oil and broad energy markets. The country is the world’s top producer of crude oil and has the most natural gas of any country on the planet, ensuring that it will be a top player in this space for decades to come. This could be especially important in the coming months and years if Brent crude oil stays elevated and Europe skirts by without falling into a deep recession.
If investors add in the possible loss of Iranian crude, this Russian crude production could be even more important. This could be especially true if the worst case scenario happens with Iran and the Strait of Hormuz sees disruptions. If this happens, demand for Russian crude could soar this year across a variety of major European markets as many nations scramble to replace Middle Eastern crude. Should this come to fruition, beaten down Russian stocks could greatly outpace the market like in 2009 when the major index tracking equities in the country put up returns of nearly 130% (see Top Three BRIC ETFs).
However, these positives do not by any means suggest that the country is without risks. Instead, Russia should probably be thought of as the one of the higher volatility plays in the BRIC bloc. In fact, in 2008, that same index which would see incredible returns in 2009 saw losses of over two-thirds in that single year, suggesting that slumping oil prices can have as devastating of an impact on the country’s stocks as strong prices can have on upswings.
Beyond this heavy dependence on oil which can work both ways, there are more issues for investors to be aware of in the country. In addition to legendary corruption, Russia has very weak institutions in terms of investor protections, property rights, and government efficiency. In fact, according to a recent competitiveness report (PDF), the country ranks 128/142 in the world for institutions, and a similarly pathetic level for financial market development (127/142) and business sophistication (114/142). Thanks to these low levels, many investors have decided to risk their capital in other emerging markets instead of worrying about the many issues that come with buying securities in Russia (see Five Cheaper ETFs You Probably Overlooked).
In addition to these structural issues, there is an upcoming Russian Presidential election that investors should be aware of as well. Current Prime Minister Vladimir Putin is widely expected to win the vote easily, but many Russians are growing disenfranchised with the prospect of his rule, especially after a recent parliamentary election which some believe was rigged. Should more of these situations happen in the near future and if more of the Russian populace grows tired of Putin’s United Russia party, investors could see higher volatility in the marketplace for the foreseeable future.
Nevertheless, given the Russian market’s heavy correlation with the price of oil and the prospect for higher prices in the near future, a play on Russia could make sense for those with a high risk tolerance (read Five ETFs to Buy in 2012). While buying some of the Russian stocks that trade on U.S. exchanges is certainly a possibility, a basket approach, via the use of ETFs, could be the way to go in this uncertain environment. Currently, for investors looking to make a play on the space there are three solid options. While they are similar, each of the products has their own key differences which investors should be aware of before attempting to make a bet on the beaten down Russian economy:
Market Vectors Russia ETF (RSX - ETF report)
For investors seeking the biggest and most liquid option in the Russia ETF world, look no further than RSX. The product trades about 4.7 million shares a day and hold $1.7 billion in assets suggesting tight bid ask spreads for pretty much all investors. In terms of sector exposure, energy dominates making up nearly two-fifths of the total portfolio and it is closely followed by the materials sector which accounts for another quarter of assets. RSX has a net expense ratio of 62 basis points a year and has slumped by 29.3% in the past six months; possibly presenting investors with huge bargains at current valuation levels.
iShares MSCI Russia Capped Index Fund (ERUS - ETF report)
The entrant from iShares in the space is ERUS, a fund that follows the MSCI Russia 25/50 Index. This index produces a fund that holds 27 securities and has a heavy concentration in the top three companies which make up nearly 50% of total assets. Additionally, energy firms make up nearly 43% of total assets in ERUS while the next biggest sector, financials, occupies just 14.4% in comparison. ERUS, which charges investors 58 basis points a year for its services, slightly beat out its counterparts in the space over the past six months by losing ‘just’ 26.8% in the period. This could mean that ERUS will experience less volatility than its counterparts and could be an ideal choice for those seeking more exposure to Russia but are still uncertain over the country’s outlook (also read Time To Consider The Small Cap Oil ETF).
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 do a substantial portion of their revenues in the country. While its focus might be on pint sized securities, the product still has a heavy focus on the energy sector as RSXJ puts 23.8% of its assets in energy firms, 19% in materials and 14.7% in industrials. The product charges investors a net expense ratio of 67 basis points a year but has had an extremely rough past six months losing 30.6% in the period. This level slightly outpaces its large cap counterparts but this could make the fund a star performer if the Russian economy rebounds in 2012.
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Disclosure: Long VWO.