Ben Aris in Moscow -

Buying Russian stocks was never about what to buy but when. That has changed in the last year and Russian hedge funds' strategies are being transformed by soaring valuations and May's sharp sell-off.

The first thing to know about hedge funds in Russia is that few of them actually hedge their investments. The number of funds working in Russia is very limited, and almost all of them follow the same strategy: buy-and-hold.

Russia's assets remain so massively undervalued that despite the stomach-churning swings, investors that protect their investments by shorting stock have found they almost always lose out.

Buy-and-hold is a strategy that has paid handsome rewards for those brave enough to follow it, as the Russian economy has transformed itself from a basket-case in the early 1990s to a newly confident oil producer with a booming consumer sector today.

Since President Vladimir Putin took over the reigns in 2000, Russia’s stock market has settled down to put in steady gains, rising from an all-time low of 38 in October 1998 to an all time high of 1745 on May 9.

With the RTS index nearly doubling twice in the last two years, a raft of new funds have been set up, partly driven by the re-emergence of the domestic mutual fund business as Russia’s growing middle class try to benefit from Russia’s growth: in the midst of the sell-off in June, Russians started buying funds – known as PIFs in Russian – and took the total under management to a new record of RUR300bn ($11.2bn).

Most mutual and hedge funds, though, are targeting foreign investors.

The latest addition is Troika Dialog’s Russia Fund with $42m under management, which joins the ranks of the established funds: Firebird Management based in New York with $2bn under management; UFG Asset Management with $211m in the pot; and Pharos which was set up about four years ago by Peter Halloran with $300m under management. All these funds have long-only strategies.

“People who invest into Russia believe it is going to grow. It is not rational to take away the Russia exposure as you can make as much from the country exposure in the mid-term as you can from the stock,” says Mattais Westmann, the manager of Prosperity Capital, which has been working in Russia for a decade and has $2.5bn under management. “The market is risky, but then that is part of the reason people are choosing to invest there.”

Prosperity Capital’s flagship fund has returned an annualised 33% since inception and the biggest hedge fund in Russia, Bill Browder’s Hermitage Capital with $4bn under management, has put in a whopping annualised gain of 36.8% a year since its inception – including massive losses recorded in the years surrounding the 1998 financial crisis.

“Our strategy is to go into a company and physically get into it to work to release some of the value that has been locked up by archaic nature of the market,” says Browder, who is now in exile in London after the Russian Foreign Ministry refused to renew his visa last year.

The gains are due to a happy coincidence of historically high oil prices and commodity prices on the one hand and low global interest rates on the other. However, the drop in the market in May suggests the business cycle has reached its peak and Russia’s equity market is moving into a new phase. Will the long only strategy still work?

Times are a-changing

The May sell-off was sparked by the Federal Reserve’s decision to hike interest rates to 5.25% – a level where traditionally “safer” markets start to look appealing. The collywobbles were compounded the threat of a global economic slowdown that brought oil off its peak of $75 a barrel to under $60 at the start of October. Other commodities were sold down too. These factors were compounded by the ongoing appreciation of the ruble against the dollar – up more than 7.5% by the start of October – which erodes natural resource-related companies’ profits.

It won’t be clear where the global economy is headed for several months yet, but clearly risk has returned and the RTS’ 100% annual gains are now a thing of the past.

The change has arrived fast and is apparent from portfolio investors' decision to rotate out of the traditional favourite raw material producers’ stocks en masse at the end of September into companies that make their money in Russia in rubles.

The big question now is whether the change is permanent. If it is, then the traditional strategy of buy-and-hold oil and gas stocks, which make up 69% of the MSCI Russia index, will no longer work.

Mangers like Browder argue that even after the recent gains Russian equities are still significantly undervalued. However, most of the funds are starting to change tack slowly.

In October, Prosperity Capital will list the Prosperity Voskhod (Sunrise) fund on London’s Alternative Investment Market, which will invest into companies and sectors currently restructuring and investing for growth – sectors other than raw materials.

“The new fund is focused on the internal value created by the ongoing restructuring rather than the external valuation creation from growth,” says Westmann. “Russia has gone from having lots of macro problems to lots of micro ones – but even those are being fixed by entrepreneurs and a state that is taking responsibility.

The long and short of it

Prosperity’s Voskhod’s fund assumes the Russian economy has gone through a fundamental change. By seeking out companies that are growing thanks to reform and restructuring, the fund assumes that investing into Russia is no longer a “plain vanilla” deal. It matters which company you choose to buy and if this is the case, then fund mangers will start to look at ways of taking the beta, or correlation with the country risk, out of their investment equation.

Russia got its first long/short fund when Red Star Asset Management set up last year, managed by James Fenkner. The fund has $115m under management, but rather than remove the Russia risk Red Star looks for valuation mismatches in stock pairs from across the CIS and Southeast Europe.

“Take a stock like [leading oil producer] TNK-BP. It is clearly undervalued when compared to BP’s stock so they make a natural pair,” says Fenkner. “Our strategy assumes that the market has already matured and most of the deep value has already been realised. There is still a lot of inefficiency in the Russian market, but there is now enough liquidity to make it possible to participate with a hedge fund strategy.”

Russia still has some way to go before it can support true hedge funds that use the sophisticated strategies of their peers on Wall Street and in the Square Mile because the Russian market remains very narrow and shallow.

“The Russian market is illiquid with only 12 stocks trading in any volume at all and there are only about four Russian stocks that you can responsibly short that won’t get called away,” says Browder.

“You could in theory short indexes but there is too little volume. There are also options, but as a 12-month put option at the money would cost 16%, the market would have to fall 16% to be worth it and if you thought the market might fall 16%, you have ask if you want to be there in the first place. So the basic US model of hedge funds doesn’t work in Russia,” he says.

However, as part of the sweeping financial reforms that the Kremlin is pushing, a market for futures and options is developing rapidly. A new law that provides the legal basis for derivatives sailed through the Duma in the first of three readings this June and should become law by the end of this year.

Even before derivatives had any legal standing – currently they are still regulated by the same laws that cover casinos – trading in futures and options has been the fastest growing business in Russia’s financial sector over the last two years. The total volume has grown from $13bn in all of 2005 to $1bn contracts signed a day by the middle of this year, according to industry experts.

“Most options are still a plain vanilla market. Some 90% of the deals are simply futures calls," says Georgy Mirel, head of options trading at Troika Dialog, which has been a pioneer in the market. "The more exotic products will come, but there are still a lot of clients out that are thinking about derivatives but have yet to test the market."

In all, 17 banks operating in Russia have applied for special licenses to conduct option trades and more are expected to join soon, while Russia’s two rival exchanges MICEX (Moscow Interbank Currency Exchange) and the RTS have been rolling out option products in an effort to make this new market their own.

UFG’s Florian Fenner is typical in that he makes limited use of such instruments in times of high volatility. At the worst point, Russia’s stocks were down 39% from the May peak, but UFG’s fund ended that month down only 5.2% thanks to Fenner’s decision to short oil major Surgutneftegaz, which earned a 23% return on the contract. But this sort of deal remains the exception, not the rule.

Send comments to: Ben Aris