Ben Aris in Moscow -

Mainstream investors have woken up to the power of emerging markets and have turned to exchange-traded funds, or ETFs, as their vehicle of choice. However, longer-term investors warn these funds are effectively "hot money" that could destabilise the fastest growing stock markets.

Russia's stock market is one of those star performers 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, meaning 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 ETFs and the investment case for emerging markets has been a happy coincidence," says 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."

Who would have thought that emerging markets would be beneficiaries of the flight-to-safety trade? But that's what has happened over the last two years as the economies of developed markets find themselves in a deep debt hole. Emerging market investments have done very well over the last two years and Russia's market was one of the best performing, up about 150% in 2009 and 22% in 2010.

Since the start of this year, Russia is the best performing Bric market, up by 15% over the first three months. The leading RTS Index passed the psychologically important 2000 mark in March as the valuation of Russian stocks overtook their pre-crisis highs for the first time in two years, and the RTS is expected to pass its all-time high of 2487.92 later this year.

Russia is now attracting considerable overseas cash and the fund tracker EPFR says that new money-flows into Russia-focused funds in the last week of March amounted to $486m, up from $139m the week before and the 15th straight week of inflows. By the end of March, assets under management in Russian-dedicated funds hit a new all-time high, breaching the $20bn mark, according to Uralsib, half of which 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," says 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 short-term gains. The point was brought home in the middle of March when all the emerging stock markets suddenly sold off after developed markets started to show signs of revival. "The Russian market is currently standing apart from this trend. As a difficult emerging market, 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 emerging markets and back towards the developed world," says Liam Halligan, chief economist of Prosperity Capital Management, a dedicated Russia fund.

Russia goes mainstream

The silver lining in the rise of ETFs is that as a mainstream investment vehicle, the word "Russia" has entered the lexicon of the financial advisors who sell funds to the small investor and the more conservative institutional investors. "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 - not least due to the continuation of low earnings multiples despite recent share price growth," says Halligan.

It's an education process that will ultimately benefit everyone, but in the meantime investors are expecting a choppy ride as worries over what will happen to the oil price dog fund managers. If the ETF investors 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," says Weafer.

In a worrying sign, Market Vectors' Russia ETF, the biggest US-listed ETF for the country, 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 as a more positive sign: Russian stock valuations on a price/earnings base are the lowest among 21 major emerging markets, according to Bloomberg. "Russia is in pretty good shape at the moment," says Julian Mayo, a London-based money manager who helps oversee about $3.5bn invested in developing markets at Charlemagne Capital. "I think it will continue to outperform."